Sports Bets at the Stock Exchange

You can think about financial markets at different levels of abstraction. Most working traders and analysts spend most of their time thinking at the level of making correct predictions: You analyze some data about the world, form a hypothesis about what some asset prices will do, and test the hypothesis by trading the assets. Often this analysis is informed by experience and connoisseurship and intuitive pattern-matching, though increasingly these days the pattern-matching is done using machine learning techniques.

Then there is the level of adaptive niches: Why do these patterns exist, and why should you be able to make money trading on them? A pattern with no explanation is a bit suspect; you want some psychological or structural explanation for why asset prices will move the way you expect and why they haven’t already.1 “Long-only asset managers like to take some credit risk and get their duration via futures, so we can make a bit of money buying cash Treasuries and selling futures” is an explanation of this form. (While “futures usually pay a bit more than cash Treasuries” is a first-level explanation.) Or “index funds rebalance on particular dates so if we buy the stocks they need to buy ahead of time we can sell to them at a profit.” Or “retail investors are buying meme stocks at irrational prices so I can make money very carefully selling them those stocks.” Some sort of story about regulations or institutional constraints or mass psychology or something, some satisfying intuitive reason for the patterns.