The House Always Wins #2: Information Asymmetry

9 March 2015
The Market Owl

If you trade and/or generally like games involving a risk/return component, The Sting (1973) featuring Robert Redford & Paul Newman is a movie you’ll enjoy.

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The movie just turned 43, but the plot is timeless – its ingredients are as old as humanity. Why?

Because for as long as people have been around, some have always known stuff that others didn’t. Moreover, the advantage this confers provided them with a strong incentive to keep it that way: there are big profits to be made in situations where you know more than your opponent. Situations in a context of information asymmetry. The applications of information asymmetry to real world issues are endless, spanning war strategy, used car sales (a Nobel Prize was awarded for this application), poker… all the way to – you guessed it: trading.

Together with Loss aversion, information asymmetry is, one of the reasons why inexperienced traders very often lose their shirts when speculating in financial markets.

The question is: How does this happen? And what has information asymmetry got to do with it?

Take the example of a retail forex broker-dealer. In its most basic configuration, a forex broker-dealer is the House in a casino. It bets against its customers: e.g. when a retail trader goes long the EUR/USD on the spot market, his broker “makes a market” by taking the opposite trade to that of his customers, thus enabling the customers’ trade in the first place. This is a 0 sum game, which way the EUR/USD moves after closing the trade will determine a gain for one of both sides, which will equal the loss for the other side (ignoring the spread, which is generally very small in currencies).

A lot of people bad-mouth market makers for this: allegedly market-making is a dirty business (particularly when one bets the wrong way :-). In our humble opinion, there’s absolutely nothing wrong in such a set-up, provided both parties have accepted the rules of the game before engaging in it, and have access to all the relevant information to inform their bet. In such a set-up, provided the underlying is truly random, wins and losses for both sides of the trade will tend to even out.

BUT: and here’s where information asymmetry kicks in, the broker-dealer has more information about you (the trader) by virtue of providing you with execution, which he can use against you:

  • Your identity (and often your background)
  • Your financial strength
  • The leverage you deploy (he lends it to you!)
  • Your track-record
  • What all his other customers are doing

Now, this is very valuable information in the context of a 0 sum game. If you operate with a lot of leverage, chances are you will sooner or later suffer from loss aversion, and cut your losses. This offers juicy profit opportunities to the other side of your trades just by sitting tight until you chicken out.

If this wasn’t enough, your tendency to chicken-out will be reflected in your track-record, which will possibly highlight other forms of bias that make you lose systematically (sign-up to Darwinia if you want a free diagnostic of your track-record)

Now, if knowing the leverage & track-record of each of his individual opponents wasn’t powerful enough, imagine you had this information for ALL your opponents.

There will be some star traders amongst your customers: what should the market maker do? Obvious: whenever he traded, replicate his trades by either:

  • Taking the star traders’ side on the flow reaching you for as long as your trader held-on to his position
  • Moving your mid-market price to make the opposite side of your star traders’ trade more appealing. This would entice novice traders who take positions randomly into taking the side of the trade which will be wrong, more often than not
In other words: do not enter trades in a set-up in which the cards are stacked up against you. Choose to trade with neutral execution venues.
Trade with organized exchanges (Futures) or MTFs (Forex, CFDs). If you don’t, you may well end-up being the consistent loser in a series of bets, without even realizing why. Which is the reason why Darwinex, where possible and more advantageous to you, clears your trades on regulated markets and MTFs.

 

We couldn’t come up with a better way to sum it up than this dialogue in the movie:

 

Doyle Lonnegan: Your boss is quite a card player, Mr. Kelly; how does he do it?

Johnny Hooker: He cheats.