When a trader believes an uptrend should continue, he (or she, or it in the case of an artificially-intelligent trader) buys. All else equal, this extends the trend. That is a self-fulfilling prophecy. When a trader believes prices should remain constant, he buys when they drop below the current level, and sells when they rise. Ceteris paribus, this extends the price level -- a self-fulfilling prophecy. Arbitrage, in the very loose sense of buying underpriced stocks or selling overpriced stocks, is also a self-fulfilling prophecy. This so-called arbitrage has neither more nor less potency in setting stock prices than trader beliefs about price trends or price levels, which is why asset prices can bubble or crash.
Talented traders can and do use their superior sense of market conditions to take advantage of less-talented traders. Floor traders in all kinds of markets typically either lose their trading capital right away or earn high returns year after year. The winners have talent. They charge the continuing supply of new losers quite dearly for the privilege of finding out that they don't have talent. Luck is involved for talented traders that lack money-management skills -- who underdiversify and take the risk that a news event will wipe out their trading capital. However, a diversified portfolio run by a talented trader team will consistently outperform benchmarks, and by large margins.
Of course, complex adaptive asset markets change, and a new set of rules could eliminate bubbles and crashes from our markets. Those rules are as-yet unknown, primarily because no major agency or foundation is funding experimental research into new market rules to eliminate bubbles and crashes (at least to my knowledge). Nonetheless, some researchers are pursuing initiatives along these lines. David Shirreff, Euromoney's managing editor, wrote a precis of my own proposal for eliminating excess volatility in foreign exchange markets.
I have written a few columns on this topic, both from the perspective of new rules to eliminate excess volatility and new trading procedures to systematically exploit the excess volatility that exists, and have posted them below. If you would like to know more about trading in complex adaptive asset markets, please feel free to contact me.
"Trading Experiment Setup One"
"Trading Experiment Setup Two"
"Trading Experiment Setup Three"
"Trading Experiment Setup Four"
"Trading Experiment Results"
Readers with questions or comments for Dr. White can call
011(525)595-6045, fax 011(525)683-5874, or email white@profmexis.sar.net
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