Why do trades occur?

[mathemagician54]

maybe this is a silly question, but why do trades occur?

Assume that we have intelligent players and players are willing to buy/sell iff they believe a stock to be under/over valued, ie for example someones not willing to sell just because he needs some $ right away, even if he believes holding the stock to be +EV.

Now if I believe a stock to be undervalued, i will buy it from someone who believes it to be overvalued. But when I learn that this person believes the stock to be overvalued, that will change my valuation of the stock since there's something he may know that I don't. Similarly his valuation of the stock should increase. If we keep increasing the level of thought, i.e he knows that I know that he believes the stock to be overvalued, yet I still buy it, that will continue to change his valuation even more until it seems like we're in some sort of equilibrium where none of us believe that it is profitable to buy or sell.

clearly this doesn't happen in the real world though. What's wrong with this argument?

[soko]

This logic doesn't always hold true because many times people will give up one good opportunity for one that is even more better, sell out of one good position to get in to a better one. Sometimes there are levels of risk that one player is not willing to take and that some other player is willing to take and a trade will occur. Sometimes people just need the cash and sell to get cash for immediate real world needs and others would rather have their money invested. Most of the time people just simply disagree if a stock is overvalued or undervalued, there is a universe of unknown variables.

Ever watch CNBC when they have a Bears vs Bulls argument where one guy is saying we are right around the corner from an economic collapse and the other guy is saying that's wrong that we will continue to grow and now is a great time to buy. It's ubiquitous, nobody will agree and the only truth is in hindsight.

[mathemagician54]

one of my assumptions was that people essentially have infinite bankrolls, i.e they will take high-variance positions so long as they are +EV, and they dont need to sell stocks in order to get cash for real world needs.

So the two points you brought up that don't go against that assumption is that they'll sell out of ojne position to get into a better one, and people disagree about the valuation of stocks.

But this is exactly my question... given that two parties disagree about the valuation of a stock, shouldn't they reach some kind of equilibrium where they agree that the stock is neither over/undervalued? (And if they're trying to sell out of one position to get into a more profitable one, why is that situation not going to reach the same sort of equilibrium?) Assuming both parties are INTELLIGENT, and don't let things like ego get in the way... they're both just trying to make the most profitable decisions.

It's true that people will always disagree about the valuation of a stock. But if you and I disagree, and we both assume that each other is intelligent the fact that you disagree with my valuation should lead me to change my valuation, and vice versa.

One of the things im not sure of is in the assumption that that people who cannot handle risk/ need to sell because they need $ for real life needs, have a negligible impact on the market (and hence we limit our discussion to people with sufficiently large bankrolls to handle high-risk but profitable positions). Is this true?

[DcifrThs]

- not all players do the same level of research
- not all players have the same abilities
- not all players are entirely rational
etc. etc.

Barron

[Shoe]

[ QUOTE ]
One of the things im not sure of is in the assumption that we can assume that people who cannot handle risk/ need to sell because they need $ for real life needs, have a negligible impact on the market. Is this true?


[/ QUOTE ]

This is almost always true. People that need to sell because they need $ for real life generally don't have enough money to move the price of a stock.

[mathemagician54]

[ QUOTE ]
- not all players do the same level of research
- not all players have the same abilities
- not all players are entirely rational
etc. etc.

Barron

[/ QUOTE ]

Point 3 is key... if they're not rational then obviously this question is trivial. But if people ARE rational/intelligent... points 1 and 2 still beg the question...

If I have done less/more research than you or I believe our skills to not be equal, and our valuation of the stock is different, it seems that our valuations should still converge based on the argument presented before.

So if you're more skillful/have done more research than I, given that I am rational I should change my valuation so that it's more similar to yours and so on until they are essentially the same.

idk i thought it was an interesting question. But maybe the main problem is in the assumption that players are rational then... but if the players here are not rational it seems that they'll be broke long term or are incredibly lucky.

[fanmail]

[ QUOTE ]
But this is exactly my question... given that two parties disagree about the valuation of a stock, shouldn't they reach some kind of equilibrium where they agree that the stock is neither over/undervalued? (And if they're trying to sell out of one position to get into a more profitable one, why is that situation not going to reach the same sort of equilibrium?) Assuming both parties are INTELLIGENT, and don't let things like ego get in the way... they're both just trying to make the most profitable decisions.

It's true that people will always disagree about the valuation of a stock. But if you and I disagree, and we both assume that each other is intelligent the fact that you disagree with my valuation should lead me to change my valuation, and vice versa.

One of the things im not sure of is in the assumption that that people who cannot handle risk/ need to sell because they need $ for real life needs, have a negligible impact on the market (and hence we limit our discussion to people with sufficiently large bankrolls to handle high-risk but profitable positions). Is this true?

[/ QUOTE ]

It's a market, not just 2 people. You pretty much never know who you trade with when trading electronically. So you don't really know that person's opinion. There are tons of opinions on over/undervalued prices. There are tons of different trading strategies. There are individuals and funds with different wants/needs.

As far as an equilibruim goes, sometimes there are tight trading ranges that can go on for minutes, hours or days. But something usually causes a move eventually. Not everyone sees the move at the same time or ever for that matter.

I know I gave a kind of jumbled response, but maybe that helps a bit.

[stinkypete]

nobody has perfect information.

if you think you have better information than your counterparty, and your counterparty thinks he has better information than you, a trade will occur.

also, assuming infinite bankrolls is just silly.

[Tater10]

Risk transfer.

If you start up a company and its now worth $10M, wouldn't it be nice to transfer some of this risk to people who can diversify? Bill Gates sold all the way up since his company was founded.

If you own a copper mine, you might be the one who best knows the price of copper will have a good chance at going higher, but what are your options? Not pay your worker and expenses? You have to go to market with your copper.

Similarly, if you make copper pipe for a living, you might also know that copper is probably going higher, but again, what are your options? You probably don't have enough money to buy all the copper you need for the next 10 years.

I think Ford did this in the palladium market about 7 years ago, they bought more palladium than they could ever need up to $1000/ounce - it went back to under $200, and Ford wound up writing off hundreds of millions of dollars in losses. Details are sketchy in my mind.

[Badger]

[ QUOTE ]
clearly this doesn't happen in the real world though. What's wrong with this argument?

[/ QUOTE ]
Your assumptions are way off, and your mechanism for trades is incorrect. Also, there are many factors that weren't addressed (motivations, information, other liabilities, taxes, morals, limited bankrolls,... there's a million things that affect what people buy/sell and when, and for what price).

Do you really not see what's wrong with your argument, or are you trying to get at something else here?

The mechanism for trades is more like a merchant putting a price tag in the window offering to buy/sell. If he's getting a ton of takers he might then realize that his price is incorrect and he should change it. Nobody stops in to say- hey I think this TV is worth $1300, not $1000. They just buy the TV and are happy they saved themselves $300. Now if there were two merchants selling TVs in a perfect market I think we could assume that the price would settle at its true value. I think this is essentially what is going on in the stock market, but so many things change what the market believes that true price should be that it's in constant flux. Sometimes there are people that correctly assume the TV is undervalued and buy it, but sometimes people think it's undervalued and buy it only to find out it was actually over valued.

EDIT- That was a bigger edit than I planned.