Exploring the Nature of “ Trader Intuition ”

Experimental evidence has consistently confirmed the ability of uninformed traders, even novices, to infer information from the trading process. After contrasting brain activation in subjects watching markets with and without insiders, we hypothesize that Theory of Mind (ToM) helps explain this pattern, where ToM refers to the human capacity to discern malicious or benevolent intent. We find that skill in predicting price changes in markets with insiders correlates with scores on two ToM tests. We document GARCH-like persistence in transaction price changes that may help investors read markets when there are insiders. THIS PAPER REPORTS RESULTS FROM EXPERIMENTS meant to explore how uninformed traders read information from transaction prices and order flow in financial markets with insiders. Since the seminal experiments of Charles Plott and Shyam Sunder in the early 1980s (Plott and Sunder (1988)), it has been repeatedly confirmed (as we will do here too) that uninformed traders are quite capable of quickly inferring the signals that informed traders (insiders) have about future dividends, despite anonymity of the trading process, despite a lack of structural knowledge of the situation, and despite the absence of long histories from which they can learn the market’s statistical regularities. It is striking that so little is understood about the ability of the uninformed to infer the signals of others. This ability constitutes the basis of the efficient markets hypothesis (Fama (1991)), EMH, which states that prices fully reflect all available information. Underlying EMH are the ideas that the uninformed will trade on the signals they manage to infer, and that, through the orders of the uninformed, these signals are effectively amplified in the price formation process. In the extreme, prices will fully reflect all available information. However, without a better understanding of how the uninformed read ∗Bruguier, Quartz, and Bossaerts are at the California Institute of Technology, and Bossaerts is also at the Ecole Polytechnique Fédérale Lausanne. This work was supported by the NSF through grant SES-0527491 to Caltech and by the Swiss Finance Institute. Comments from Ralph Adolphs, Colin Camerer, Fulvia Castelli, John Dickhaut, John Ledyard, Charles Plott, Tania Singer, the Editor, an Associate Editor, four referees, and seminar participants at Norwegian School of Management, Haute Ecole des Hautes Etudes Commerciales (Paris), Northwestern University (Kellogg), National University of Singapore, Okinawa Institute of Science and Technology, Rice University, University of Zurich, University of Louvain, University of Texas (Austin and Dallas), the 2007 Caltech-Tamagawa Neuroscience Symposium, the 2007 Japan Neuroscience Society meetings, the 2008 meetings of the Swiss Finance Institute, the 2008 Western Finance Association meetings (especially the discussant, Heather Tookes), and the 2008 International Meetings of the Economic Science Association are gratefully acknowledged.