Understanding your "opponent's" trading account is akin to keeping track of the number of chips your opponents have during a game of poker-- the amount of cash your opponents have will have an impact on the way they play the game.
One thing about stock market crashes that fascinated me is trying to understand where the money and capitalization value goes. I have been working over the idea of the existence of "phantom capitalization" in the stock market as a result of stock prices being bid up and I was interested in trying to understand the mechanics of a stock market bubble. So I was basically trying to model a feedback loop were people start pouring more and more money (and leverage) into the stock market, thus creating the illusion that everyone has more equity via "phantom equity." The process repeats until it is unsustainable and things fall apart.
I believe that there is a disconnect with this mode of thought since people are fooled into thinking that this equity is real and the harsh reality sinks in when the inflated stock prices tumble which wipes people out. The real objective of participating in the stock market is to buy and sell stocks to eventually cash out with more money than you started. By playing by any other rules instead, I would argue that the investor is fooling themselves when participating in the stock market. Unfortunately, the calculation methods used to value equity is somewhat faulty and is prone to enticing people into inflating stock market bubbles.
The first thought that came to mind was to try and simulate players and their interactions in the stock market; trying to understand the impact of their buying and selling of equity and how it would look like in their trading accounts. Obviously, this is a pretty hard problem as the real stock market has many individuals and tradable securities. Going for the full monty is obviously too complicated so I decided to sandbox the whole issue and have 2 players with cash and a single tradable stock which both players owned at the beginning. When one player issued a buy order, the other had to sell at the same price and volume and by using this simple model, I wanted to see what a stock bubble would look like under this isolated situation.
I managed concoct a trading pattern between 2 players where they could buy and sell and equity at increasing prices while keeping the amount of money and the number of stocks they had on hand constant. However, through the act of trading and using the standard method of calculating the "average action price" of each person, I was able to inflate the price of the stock and thus was able to create phantom equity for each individual. I have included a screen shot of the simulation I performed in the image below (click for the full sized image).
In this rather simple simulation where I kept the volume constant, I noticed that the swings in the "cash" column got larger and larger as the price the stock increased. In more realistic situations, I would presume that the volume would taper downwards to reduce such large swings in one's capital account. I would surmise that this also wouldn't apply to just individual investor but is also true for computer systems engaged in high frequency trading. But the main point is that it is possible to observe the inflation of networth of 2 parties trading in a single market and that it should be possible to extend this model to a many people market with many different stocks.
For the above calculation, I didn't take it all the way to the point where both persons were leveraged to continue bidding up the equity price, but it should be quite evident that the swings would get larger until the point where neither person A or B would be able to leverage themselves any further. Supposing that a dormant person C existed, any sell off by this person would result in a catastrophic crash as margin calls are made.
From a technical trading standpoint, I think it would be an interesting exercise to find ways of watching the volume and price as an indicator of bubbles in the stock market. One concept would be to watch for decreasing volume while prices rise as an indicator of a bubble since higher prices will equate to lower volumes as a stock is traded up. I would also expect that the converse be true in that volume would likely increase when stock prices are low since it takes more of the same stock to move the same amount of money.
What I am very interested in trying to figure out as a result of this simple calculation is an empirical method of guessing at the "action prices" of other participants in the stock market. I have a hunch that people will have a tendency to sell off their stocks after turning a profit and will likely end up spending their profits on buying other (inflated) stocks. The whole process continues until a bubble occurs and it pops, leading to the destruction of phantom equity.
One method of making money in the stock market is simply knowing when to get out and staying out when a bubble occurs. And the trick to understanding when a bubble is occurring is figuring out when there is too much phantom equity vs the amount hard cash available.
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