For the quantitatively inclined

V

vladiator

Just came across this one. Somewhat interesting.
Enjoy.
V.
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"The Predictive Power of Zero Intelligence in Financial Markets"

BY: J. DOYNE FARMER
Santa Fe Institute
PAOLO PATELLI
Sant'Anna School of Advanced Studies
Santa Fe Institute
ILIJA I. ZOVKO
Santa Fe Institute
University of Amsterdam

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http://papers.ssrn.com/paper.taf?abstract_id=483603

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Paper ID: AFA 2004 San Diego Meetings
Date: November 16, 2003

Contact: PAOLO PATELLI
Email: Mailto:paolo@black.gelso.unitn.it
Postal: Sant'Anna School of Advanced Studies
Department of Economics
I-56127 Pisa, ITALY
Co-Auth: J. DOYNE FARMER
Email: Mailto:jdf@santafe.edu
Postal: Santa Fe Institute
1399 Hyde Park Road
Santa Fe, NM 87501 UNITED STATES
Co-Auth: ILIJA I. ZOVKO
Email: Mailto:zovko@santafe.edu
Postal: Santa Fe Institute
1399 Hyde Park Road
Santa Fe, NM 87501 UNITED STATES

ABSTRACT:
Standard models in economics are based on intelligent agents
that maximize utility. However, there may be situations where
constraints imposed by market institutions are more important
than intelligent agent behavior. We use data from the London
Stock Exchange to test a simple model in which zero intelligence
agents place orders to trade at random. The model treats the
statistical mechanics of the interaction of order placement,
price formation, and the accumulation of stored supply and
demand, and makes predictions that can be stated as simple
expressions in terms of measurable quantities such as order
arrival rates. The agreement between model and theory is
excellent, explaining 96% of the variance of the bid-ask spread
across stocks and 76% of the price diffusion rate. We also study
the market impact function, describing the response of prices to
orders. The non-dimensional coordinates dictated by the model
collapse data from different stocks onto a single curve,
suggesting a corresponding understanding of supply and demand.
Thus, it appears that the price formation mechanism strongly
constrains the statistical properties of the market, playing a
more important role than the strategic behavior of agents.
 
To me it says that price changes are due to a change in time from some point. Let's say price has just changed to some level. There follows a period of consolidation and then a move to a new level.

What is being said is that the markets are moving as a result of the random influence of arriving orders and order cancellations. Price diffusion has been demonstrated to vary according to the square root of time (proved by Einstein) if it is random and if price had a 'memory' it would move from its origin at a rate which is proportional to time, assuming it moved with a constant speed.

Farmer has authored a few papers about this. He and his group developed a way to trade based on a model estimating the arrival and cancellation of orders and how price was affected by that process. He is saying, I think, since this process is generally one of limited scope it has an effect on what stategies can be employed to trade successfully.
 
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