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army1987 comments on A proposed inefficiency in the Bitcoin markets - Less Wrong
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O hai.
Imagine if everyone agreed that the best way to calculate Bitcoin's expected future value was to look at a single source of news: the Bitcoin guru. Every day, if the Bitcoin guru goes on TV with his thumbs up, then everyone agrees that that is worth a Bayesian update of 1.25x to the expected future price, while thumbs down is worth a Bayesian update of 0.8x. And no one has a better model of how the Bitcoin guru's thumb works than the fair-coin-flip model.
In other words, pretend you know that everyone's expected future value of Bitcoin follows a log random walk. Now you can use inductive reasoning to conclude: If the expected future value of BTC is $1000/coin today, then it will be either $1250 or $800 tomorrow.
I used to think an "efficient market" was necessarily a market which current price captures people's consensus expectation of future prices. But in my example, it seems possible to have a guaranteed-positive-return trading strategy: investing say 10% of your portfolio in BTC, and constantly trading as required to rebalance your 10% asset allocation.
There are a few names you can use for that...
"Drag Trading": trading that causes market prices to be dragged toward their past value and away from their current expected future value.
"Shannon's Demon": a kind of Drag Trading - trading to maintain a constant % of BTC in your portfolio, i.e. near-continuous portfolio rebalancing.
"Kelly Criterion Trading": An instance of the Shannon's Demon strategy, where you choose your asset percentages in proportion to their long-term future relative value, which you derive by asking yourself what relative percentages of the world's wealth are stored in your different asset classes.
My big point has two parts:
I think I've shown that an "efficient market" might not have prices that directly reflect a consensus of future prices, but instead might show some "price drag".
Bitcoin's wildly swinging prices is evidence that it is lacking this "price drag", unless the model of expected future price drag is even more volatile than the exponentially-volatile one in my thought experiment.
Therefore drag-trading Bitcoin seems promising.
I'm having a little trouble understanding the model.
Is the Bitcoin Guru correct in his predictions? If so, is he taking into account that people might be using your drag trading strategy? If not, then it sounds like the strategy no longer offers guaranteed returns.
Yes, the Bitcoin Guru makes accurate predictions.
No, he doesn't take into account people's drag trading behavior, because his conclusion is dominated by evidence about the underlying value of Bitcoin as usable money in the long-term.
Hmm, I might just be misunderstanding.
To make slightly more concrete what it means to say that the Guru's predictions are accurate, could we say that all his predictions are for what the price will be on Jan 1st, 2019? So when we say he's accurate, we mean that on that day the actual price will be some starting price, times the product of a bunch of 1.25s and .8s according to whatever his predictions were on all the days in between.
Does this match what you had in mind?