Price Distribution and Probability of a Winning Bet

[Northern boy 10]

Hey all, havn't been here in a bit, thought i'd contribute.

 

 

In a straight-forward trade, your probability of winning is dependent on the risk/reward ratio(i'll call bet ratio) available to you. The bet ratio available is dependent on the number of participents in your market(who use up these ratios). The more participents, the more betting ratios, the more evenly price is distributed.

 

 

 

 

 

 

 

What i mean by price distribution can be easily seen by comparing QQQQ and EBAY. Because the Q's market is more elaborate, the probable outcomes of a bet are more accuratly realized by price in the given time-frame. For example: one plays a bet with a reward of 3 points and a risk of 1 point. In an elaborate market, he loses 3 times more than he wins and breaks even. Distances for price to travel are matched with a probable frequency (i.e.: price can move 4 points once, 2 points twice, 1 point four times)

 

In EBAY, it's not the case. The lack of participents creates a lack of bet ratios... and the distribution of price does not reflect an elaborate market. The reason the Q's price distribution appears more volatile in the short-term is because it is realising the probabilities of every bet more accuratly. Also, in EBAY, the ratio of day traders to long-term traders is less, pushing price trends.

 

So...the odds of a traders success is much more likely in an unelaborate market, where the chances of his bet ratio being matched by an opposing bet with the same ratio at any given point in time are less likely.

 

If liquidity is not an issue, there's no reason imo to be playing in a more elaborate market than the trader needs to. to find the bet ratios that aren't being used just make a judgement call with the chart or run enough data in excel and find distance/frequency pairs that are inefficient.

 

ps: I put the post in this section because although it's not MP, it's alot about observing the distribution of price and can be analyzed with MP.

Edited August 4, 2008 by Northern boy

[Northern boy 10]

eg, markets differ in degree of difficulty.

 

lol can i get a witness?

[Northern boy 10]

Actually, I'm going to make a list of markets in order of difficulty to trade. It will allow new and experienced traders to find just enough liquidity without being in a more elaborate market than necessary. If you weren't already familiar with this concept it will make you that much more money and it will save new traders boat loads.

 

if any of all this doesn't make sense let me know.

[BlowFish 10]

Are you implying 'elaborate' markets have less inefficiencies and so are harder to find a statistical edge in? Are elabroacy and liquidity always correlated?

[Northern boy 10]

Yes, that's it. All else aside, I think if one traded blind they would be significantly more ahead in the latter market than the former.

 

the distances for price to travel aren't paired with their corresponding frequency as efficiently. The trader's r/r wouldn't break him even in the latter market, as it instinctively should. If one picks the appropriate r/r I think there's an advantage in these distance/frequency inefficiencies.

 

I wouldn't assume that the correlation is perfect between liquidity and elaboracy(not a word?), but at a certain point there's enough room for funds to run programs. Not only does the r/r break even, but the odds are worse because they watch the books and open orders.

[darthtrader2.0 10]

I'm not sure I totally agree with this. First, by "elaborate" aren't you simply refering to volatility if your only looking at price?

I guess there is another factor in there that I do agree with as far as the participants motivations for trading the instrument. Q's have more volatility because of the arbitrage players, ect...I'm not sure I agree though that this correlates much with liquidity. I think you have to take into consideration that the purpose of a market is to price an instrument forward and the real reason that Q's have more volatility than ebay is because its fundamentally harder to price Q's forward than ebay.

The real problem though is if you compare this idea between corn futures, eur/usd in forex and a small cap equity X on the AMEX.

 

eur/usd is far more deeply liquid but you don't see crazy volatility since the variables trying to be priced are so huge and the rate of information that effects the participants trading is slower. Are corn futures harder to trade than equity X? How would you order these 3?

[BlowFish 10]

As an aside there are a couple of things that have a big impact on volatility 'thickness' (volume) is one of them as is 'granularity' (tick size). Good old Harris goes into great detail why.

[darthtrader2.0 10]

Good old Harris goes into great detail why.

 

Blowfish, any chance you can do a review of this book? Maybe point to parts that you found interesting? I'm not sure what it is about this book that it defeats me without mercy.

[BlowFish 10]

I have planned to for a while. Tbh I am not sure how to approach a review, there is so much information in there. It's one to read small chunks at a time thats for sure it took me about 6 months but I use it as a reference. I guess that information overload might be one of the issues. I find the sidebars with market anecdotes and historic illustrations help break up the subject material.

[darthtrader2.0 10]

Well, I've tried the past 2 nights to read some more of Harris but I give up for now. While its loaded with information I have to say I hate the writing style. The whole thing seems kind of scatterbrained and the sidebars kind of drive me nuts.Like the volatility chapter...just when it starts getting good the chapter ends and moves to another concept.

I think another problem I have with it is I have a real problem with the whole concept of informed and uninformed traders.

I found some sample pages on google books of Empirical Market Microstructure and it refernces Harris as a broad overview but references Market Microstructure Theory by O'Hara as the standard reference. I'm going to move on to that and pick up Harris later.

This microstructure book sounds baddass too even though it doesn't reference microstructure in the title:

Asset Pricing under Asymmetric Information: Bubbles, Crashes, Technical Analysis, and Herding by Markus K. Brunnermeier.

Here is also something from Empirical Market Microstructure that to me makes alot more sense than the concept of informed/uninformed traders:

"Liquidity is created through a give and take process in which multiple counterparties selectively reveal information in exchange for information ultimately leading to a trade."

Edited August 14, 2008 by darthtrader2.0

[BlowFish 10]

Information asymmetry is one of the cornerstones I guess. I think I can see how Harris is organising things which kind of helps. Broadly he takes each type of participant and goes through there agendas and how they operate. I wonder if O'Hara identifies the same participants or categorises them in a different fashion?

 

 

The whole discipline of market microstructure seem relatively new as a whole and was totally new to me. I picked up Harris as it just seemed to have the edge with the reviews though to be fair both books are critically acclaimed. (I did have a couple of recommendations for it to). I starting reading and it was one wow moment followed by another. I found it quite mind expanding (I have a small mind to start with!). Actually they both seam fairly 'advanced' books. I can see how you might find Harris disjointed, especially with the sidebars (I love those) but I thought his writing still had a clarity. I did read pretty small chunks at a time though.

 

Let me know how you get on with O'Hara.

[Northern boy 10]

I'm not sure I totally agree with this. First, by "elaborate" aren't you simply refering to volatility if your only looking at price?

I guess there is another factor in there that I do agree with as far as the participants motivations for trading the instrument. Q's have more volatility because of the arbitrage players, ect...I'm not sure I agree though that this correlates much with liquidity. I think you have to take into consideration that the purpose of a market is to price an instrument forward and the real reason that Q's have more volatility than ebay is because its fundamentally harder to price Q's forward than ebay.

The real problem though is if you compare this idea between corn futures, eur/usd in forex and a small cap equity X on the AMEX.

 

eur/usd is far more deeply liquid but you don't see crazy volatility since the variables trying to be priced are so huge and the rate of information that effects the participants trading is slower. Are corn futures harder to trade than equity X? How would you order these 3?

 

I don't have intra-day futures or currency charts but I'd be surprised if they weren't elaborate. By elaborate I don't just mean volatile.. volatile doesn't specify anything. I mean the presence and frequency of each price swing.

 

I don't think the Nasdaq has short-term volatility because it's difficult to price forward, who's re-evaluating it on a minute-to-minute basis? Its not just the Indexes... all the large cap stocks move like this. They're being traded by programs. The risk ratio is getting taken out 10 times before the stock climbs to touch a reward ratio, so where are the chances for a retail trader?

 

I think this is one of THE most important factors to a retail trader's success. It doesn't matter if you use a 3 to 1 R/R, If the market you trade hits your risk 5 times before reward it's not going to work. Traders must select their markets carefully, or ignore this obvious factor at their own loss.

 

ts

ebay

aos

air

 

compare these to what you trade now, apply your R/R and see. I don't trade a straight-forward strategy and I wouldn't even ignore this.

[darthtrader2.0 10]

I don't think the Nasdaq has short-term volatility because it's difficult to price forward, who's re-evaluating it on a minute-to-minute basis?

 

Well first off, are you Dee from Stocktalk?

To answer your question the "programs" are evaluating NQ at the millisecond level...not minute to minute...

I do agree with you overall though...basically at the retail level we negate the 3rd dimension of "volatility". Your simply giving that dimension a name.

This idea though is something that hardly has not been studied. Just google "volatility surface" instead of reading about useless 2D "volatility".

[darthtrader2.0 10]

Information asymmetry is one of the cornerstones I guess. I think I can see how Harris is organising things which kind of helps. Broadly he takes each type of participant and goes through there agendas and how they operate.

 

Yea I don't know, like I said, I have a real philosophical problem with the informed vs uninformed trader deal...

I have to deal with these idiots everyday at my "day job"...I can assure you, no one cares the least about this stuff....its just a "job" with the possibility of making "alot of money". I've never met an institutional trader who was not some sports nut who wants to talk football instead of markets.There is no asymmetric information on an index that is not priced in IMO...

[BlowFish 10]

Northern boy sorry to go off topic a bit with microstructure.

 

Darth, Harris talks about informed and un-informed. They are quite big categories, of course all this 'smart money' BS dosen't help as people hear informed and think 'smart money. You also have to fit in utilitarian traders (whose objective is not necessarily profit) into the puzzle. Of course he talks about the circumstances that price itself is informative. It's a fascinating subject.

 

Northern Boy - you describe elaborate as the presence and frequency of each price swing. Do you factor the magnitude of each swing into that?

 

I am thinking that markets that 'back and fill' a lot are easier to trade without too much regard to overall direction. (fade BO's buy S sell R type approach). whereas markets that do nt back and fill alot straight forward 'trend following' is likely to be easier.

 

I guess this is market 'character' rather than elaboracy. Might be helpful to come up with some kind of working definition of elaborate?

[Northern boy 10]

Well first off, are you Dee from Stocktalk?

To answer your question the "programs" are evaluating NQ at the millisecond level...not minute to minute...

I do agree with you overall though...basically at the retail level we negate the 3rd dimension of "volatility". Your simply giving that dimension a name.

This idea though is something that hardly has not been studied. Just google "volatility surface" instead of reading about useless 2D "volatility".

 

are you Nate from stocktalk? lol. I'm quite sure this is an issue that isn't new, I'm bringing it up because new as well as experienced traders don't take time to consider this, and it plays a huge factor. I didn't know it had a name.

[darthtrader2.0 10]

are you Nate from stocktalk? lol. I'm quite sure this is an issue that isn't new, I'm bringing it up because new as well as experienced traders don't take time to consider this, and it plays a huge factor. I didn't know it had a name.

 

Hahaha, gone to town with your Yen/S&P correlation ideas, ehh canadian?

It actually is rather new, I haven't jumped into Gatheral's The Volatility Surface because I'm still gaining the mathematics to understand it. However, I do believe you are correct, there is this 3rd dimsenion of volatility we don't talk about that is "gamma-ish", but whatever you want to call it its more 3d and overall across strike prices than the gamma of a single strike.

[darthtrader2.0 10]

Darth, Harris talks about informed and un-informed. They are quite big categories, of course all this 'smart money' BS dosen't help as people hear informed and think 'smart money. You also have to fit in utilitarian traders (whose objective is not necessarily profit) into the puzzle. Of course he talks about the circumstances that price itself is informative. It's a fascinating subject.

 

ack, you clearly understand something in Harris that I do not. You really should make a microstructure thread and spill the beans...I want to be fascinated by this subect and then maybe I can possibly pay you back for such a thread with my own "take" but I'm totally brought to a stand still by the language. The idea of a utilitarian trader simply does not compute on any level to me.

How about informed trader == front runner? How off is that? I know I have a weakness with digesting theory if I can't see how it fits into a pragmatic strategy, even if the theory makes total sense.

[BlowFish 10]

When you have had a crack at O'Hara perhaps we can compare notes. I might get that too one of these days.

[darthtrader2.0 10]

When you have had a crack at O'Hara perhaps we can compare notes. I might get that too one of these days.

 

Yea I dont know, I got it this week but have barely opened it.

Ive really broke through some barriers knowledge wise in the past few weeks and honestly, I think once you get past the pure microstructure trade mechanics most of this stuff is a bunch of nonsense.

I would love to compare notes, here are my mental notes as far as high frequency trading and microstructure:

 

First, I think this whole business suffers from this concept of "phd-ism" that I have. Somewhat of a game theory concept where it matters far less that what you know has utility than if you can make the opponents in the game believe what you know has utility. Objectively, you are far better off in the game of life if you can make everyone believe you know something that is bogus than if you actually knew something that is true but no one believed you, phd-ism.

Thats somewhat how I view all these microstructure ideas when you really cut to the bone.We are talking about a game theory model with X participants, x == the number of individual traders making trades over Y time...the variables at the high freq level are not just unknown, they are "unknowable" for the sum of x so the market can not be truely "gamed".

My interest with this stuff though is that given enough data, time and knowledge, can you "game" the market better than 50% of the time.

To me that is an obvious yes, or no one would be able to make a living as a trader.