The Hindu Business Line : Market ecology

IF YOU actively trade in options, you may be aware of a few market intricacies. The traders, for instance, do not use valuation models to find out the fair value of options. Instead, they use a rule of thumb. If an option trades at more than 3 per cent of its strike price, it is considered expensive.

In classical economics, you are supposed to analyse all available information and then take a rational decision. That means using half a dozen inputs to choose the lowest strike price, as the objective is to maximise profits. By that yardstick, the 3 per cent rule may seem irrational.

We can, however, apply the Adaptive Markets Hypothesis to explain such behaviour. What is it? Andrew Lo, a Professor at the Massachusetts Institute of Technology, put forth this hypothesis. It essentially applies the evolutionary principles to economic decisions. Professor Lo argues that individuals base their decisions on a simple trial and error process shaped by past experiences. The 3 per cent rule is an example of such behaviour.

The participants in the options market are the `species'. The traders who use the 3 per cent rule are one kind of species. The professionals who use the valuation models are another kind. Together, they make up the "ecology" of the market.

If the traders are in large numbers, the 3 per cent rule will prevail. This may force the model users to drop out of the market or adopt a different method. Similarly, if the model users are in large numbers, the traders may adopt a different rule. There is a continual tussle for survival, just as in the Darwinian world of evolution. And it is this fight for survival that creates the so-called irrationalities that the classical economists observe.

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