The Predator’s Dilemma

In the second half of Chapter 10, Larry Harris explores the economics of being “smart.” If you’re an informed trader, your life is a constant battle against competition and the paradox of your own success.

Orthogonality: The Secret to High Profits

In trading, it’s not enough to be right; you want to be right when everyone else is wrong.

• Highly Correlated Estimates: If everyone uses the same data and the same models, they all try to buy at the same time. This eats up all the liquidity and kills the profit.
• Orthogonal Estimates: If you have a unique way of looking at the world, you can trade when nobody else wants to. Liquidity is cheap for you because you aren’t competing.

The Role of the “Losers”

Here’s a hard truth: Informed traders cannot make money trading with each other. In a room full of geniuses, they eventually just stop trading because they all know the same thing.

Informed traders need Uninformed Traders (the investors, hedgers, and gamblers we met in Chapter 8). The uninformed traders are willing to “lose” money to the pros in exchange for the services the market provides (like retirement saving or insurance).

The Market Efficiency Paradox

This is one of the coolest concepts in the book.

1. If a market was perfectly efficient, the price would always equal the fundamental value.
2. If the price always equals the value, there is no profit for informed traders.
3. If there is no profit, informed traders stop doing research.
4. If they stop doing research, the market stops being efficient.

The Resolution: Prices are never 100% efficient. They are always “wandering” around the fundamental value. When they get too far away, the pros step in, make a profit, and push the price back toward reality.

The Three Levels of Efficiency

Traditional finance defines efficiency in three ways:

• Weak-Form: You can’t get rich by looking at old price charts (Technical Analysis is dead).
• Semistrong-Form: You can’t get rich by reading the news (it’s already in the price).
• Strong-Form: You can’t get rich even if you have inside info (this is rarely true).

Harris adds a Microstructure Definition: A market is efficient if the price reflects all information that can be profitably traded upon. If it costs $1,000 to find a piece of info that only makes you $500, that info will never be in the price.

The Trade-off: Accuracy vs. Liquidity

There is a tension between having “perfect” prices and “liquid” markets.

• If we let insiders trade freely, prices will be very accurate, but regular people will be terrified to trade because they know they’ll get fleeced.
• If we ban insider trading, markets are more liquid (regular people feel safer), but prices might stay “wrong” for longer.

Public Info: The Great Equalizer

This is why things like the SEC’s disclosure rules or the USDA Crop Reports are so important. When the government publishes high-quality data for free, it makes the market more efficient without allowing the pros to take a huge bite out of the uninformed.

Next time, we’ll meet the most annoying players in the market: The Order Anticipators (Front-runners and Squeezers).

Next Post: Order Anticipators: The Front-Runners