Information and Knowledge Risk

Mathematicians many times view trading in the context of game theory. If we examine trading from this perspective, then, because trading involves prediction and prediction requires information, we quickly come to the realization that trading is at bottom a game in which information would seem to be the most significant variable factor. Nothing ever happens in markets until and unless someone changes his mind.

What is the principal cause of a trader changing his mind? The acquisition of new information, undoubtedly.If you do not own Microsoft shares or T-Bills or July corn at 10:00 A.M.,but do own one or more of these at 1:00 P.M., then obviously something has occurred that changed your mind about the desirability of owning these assets.I’ll lay heavy odds that this something was your acquisition of some sort of information concerning the asset(s) you subsequently bought.

Information comes complete with its own built-in risks, and these pose a serious difficulty for us. If a new piece of information comes into our possession,we must answer several questions correctly, and on occasion we must do this immediately or almost so. First, is the information relevant to our position in the market, and how immediately relevant is it? Fortunately,this question tends to be pretty easy to answer.

If we’re trading IBM shares,we recognize instantly that a screeching headline about, say, soybeans has no relevance to our situation. If the President proposes a new health care plan, this might be relevant. IBM might, down the road a piece, obtain a fat contract for the computers needed to manage the patient database or something similar, but the immediate effect of such an announcement on IBM’s share price is likely nil. If IBM and Cisco Systems announce

that they’re exploring some sort of joint venture, however, it’s a dead cinch that this news will affect our position materially right this minute, and for some little time to come. Unfortunately, not all information is as unequivocal as these examples may imply.More important and less easily decided, is this new information accurate?Is the source reliable, has the information been confirmed, can it be confirmed? Might it be an honest error, for instance a simple typo in a newswire story?

Even more problematically, might this putative new information turn out to be instead deliberate disinformation being spread around by another market participant? Naahh, that would never happen, would it?As if these questions aren’t sufficiently difficult, on obtaining a new piece of information we must ask ourselves whether this information is timely.Do most or all the other market participants already have it, too?

Certainly we must assume that, if a large majority of participants in a market have had this information in hand for some time before we obtain it, they’ve already made their decisions and this market has already changed price to reflect any changes in the collective market view. When this is the case, we must as a rule discard this information as being useless for our subsequent market decisions.

Here the difficulty is obvious:how can we possibly figure out how many other traders have already acted on our purportedly new bit of information?This problem of evaluation becomes still more complex when we ask ourselves the remaining question, specifically, is this new information complete? Do we have the whole story, or is there more information pertinent to this information shortly to come?

Is the source of the information playing the “good news/bad news” game by releasing a piece of mildly favorable news about a company, a company’s debt, or a futures market, with some absolutely rotten news soon to follow? How can traders resolve all these questions about and vagaries of information?We can’t. At least, I freely admit that I can’t. If you can, that’s terrific and would you please send me a detailed how-to commentary! In the meantime,I’ve accepted as an axiom that I, as a trader, am at or near the bottom of the information chain.

I firmly believe that I will never have information that is simultaneously relevant, accurate, timely and complete, and I trade according to this premise.This viewpoint directly implies that I must stay away generally from very short-term trades, day trades, and scalping, and I do, with rare and very specific exceptions. Why? The shorter the term of the trade—any trade, any market—the more seriously the result of the trade will be affected by the indifferent quality

of the information I have, and by the introduction of new information into the marketplace during the term of the trade. The arrival of new information relevant to a market is not predictable, except when its introduction occurs on a previously published schedule. Taken another way, the short-term trade has less time, hence less opportunity, to recover from the appearance of adverse information.