Who Are the Market Players?

From the preceding example, it is obvious that a number of different individuals participate in establishing the price of a security. Academia has divided these types of participants into three separate categories: informed, noise, and liquidity players.

The early Efficient Markets Hypothesis presumed that only informed investors acted within the marketplace to establish a price. These players supposedly interpreted new information rationally and adjusted the market price of a security to its equilibrium value immediately. This strict interpretation has been relaxed considerably. Now the informed investor is considered similar to the more historical type, called the “professional or smart money investor,” who can be just as affected by bias and misinformation as any other investor or trader. Professional speculators, position traders, hedge fund managers, professional arbitrageurs, and insiders are considered to be in this category.

Noise is a term coined by Fisher Black (Black, 1986) and is used to describe the random activity around the equilibrium price. Academically, the uninformed market participants are the noise players. A more widespread and older term is the public. Most mutual fund managers, pension fund managers, traders, and technical analysts are considered also to be in this category, even if they are professionals. The distinction between informed and uninformed is blurry, of course, and it’s only useful in certain sentiment statistics generated by each group (see Chapter 7, “Sentiment”). All types of participants are human and subject to the same universal human biases and cognitive limitations.

Liquidity players are market participants who affect prices in the markets for other reasons than investment or trading. An earlier example is the estate that wants to liquidate securities for needed cash. This type of player makes no investment decision but affects the market for a short time with its liquidation. Another example is the index fund that is forced to buy and sell a security based on its addition to or deletion from the index that the fund is following. This causes an outside effect on each security’s price with no regard for its investment value by itself.

Too often, these three participant types are considered as separate and distinct groups. However, they are changing constantly. Arbitrageurs sometimes act as uninformed players, members of the public learn and change categories, insiders misjudge the marketplace, and so on. Experience, as well as knowledge, is important and changing. In short, the marketplace is not a stable system headed in a straight line toward equilibrium. The interaction is dynamic and nonlinear. The system is complex.

Source: Kirkpatrick II Charles D., Dahlquist Julie R. (2015), Technical Analysis: The Complete Resource for Financial Market Technicians, FT Press; 3rd edition.