Just to clarify, we are both high schoolers. No one is at risk of losing a bunch of money here :)
I have a friend who’s fascinated by cryptocurrency trading, especially with recent events like crypto going up. He doesn’t actually invest in crypto though (that would be illegal). But he does spend a lot of time running trading simulations of the S&P500 using simple strategies (Claude’s wording of this post described it as “things like setting buy/sell limits based on moving averages that could be implemented with basic Python code”).
I want to convey the idea of market efficiency to him, but his unintuition is unintuitive to me. I don’t know what building blocks he would need to understand market efficiency.
1.
How do you develop an intuition for why strategies that look good after-the-fact might not actually be good a priori? Do I bother explaining overfitting, for instance?
2.
How do I communicate that PhDs with way more computer resources are going to “eat up” any market inefficiency? How do I convince him that this isn’t theoretical nonsense?
3. There seems to be something fundamental about market efficiency that’s hard to grasp until you’ve developed certain intuitions—like understanding that you can’t simply exploit a market inefficiency to generate unbounded returns, even with unbounded capital. How does one develop these intuitions?
4. Should I even try to discourage this? Perhaps paper trading in this way, even if it’s just peering at noise, has educational value? On the contrary, peering at noise seems to neither discourage gamblers nor provide substantial educational value for them.
This post co-written by Claude. The original draft from Claude is viewable here.
“Market efficiency” is a useful model but one shouldn’t confuse it with reality.
Where exactly does the market efficiency (er, inexploitability (by me or my friend (when we use simple strategies))) model detach from reality? Can we find an expectation that we disagree on?
The existence of people like your friend are why the market looks efficient to people like you.
Less serious response: Paper trading doesn’t normally affect market prices.
More serious response: Why did you say the market looks efficient to people like me instead of saying that it is efficient relative to people like me? I can’t identify market strategies that work (and I expect that he can’t either). More specifically, I expect that strategies that are readily available to the either of us can’t be used by the either of us to make substantial profit, but they might be exploitable by e.g. a computer with immediate access to the price of an S&P500.
In this context, I don’t think there’s a significant difference between “looks efficient to people like [you]” vs “is efficient relative to people like [you]”.
But more importantly, the best way for your friend to learn how efficient the market is is by him trying to beat it and failing. He’ll learn more about math and markets that way than if he listens to you and stops trying. I think he’s making the right decision to ignore you. By paper trading, he can do this without risking significant capital.
As for measuring the quality of a strategy after-the-fact, a good tool is Sharpe ratio.
Ok, I will try to nudge him in the direction of analyzing risk mathematically.
If he implements the strategy using python, do you think p-values are a good enough tool to analyze whether his proposed strategy is better than luck, or would I need a more complex framework? (If I understand correctly, the strategy he’s using doesn’t involve any parameters, so the risk of overfitting is low.)
That’s a complex question. A p-value is theoretically useful, but so easy to misuse in this context that I’d advise against it.
Quantitative finance is trickier than the physical sciences for a variety of reasons, such as regime change. If you’re interested in this subject, you may enjoy this thing I wrote about the subject. It doesn’t address your question directly, but it may provide some more general information to better understand the mathematical quirks of this field.
In addition, you may enjoy Skin in the Game by Nassim Taleb. (His other books are relevant to this topic too but Skin in the Game is the book to start with.)
The market isnt efficient. Which isn’t to say it is easy to beat. Your friends strategies don’t sound promising. It also seems strange to me he is obsessed with crypto and thinks it will do well but isn’t a crypto investor. Sounds pretty inconsistent with his beliefs.
It’s worth remembering many versions of ‘,,the market is efficient’ are almost or totally unfalsifiable.
It’s illegal, as mentioned in the post.
Why? The market being mostly efficient relative to my friend seems easily falsifiable, if he makes a bunch of money trading on the stock market. Then, well hooray! theory falsified. On the other hand, if my theory is that the market is inefficient relative to my friend, I have no way of falsifying this, any failed attempt to get money from the market does not falsify the conclusion that the market is inefficient (but it does provide evidence against the hypothesis).