Toward a theory of marginally efficient markets

TLDR: In this paper, the conditional entropy concept is used to identify a small probabilistic edge that smart speculators can exploit, and a perfect random walk has this entropy maximized, and departure from the maximal value represents a price history's predictability.

Abstract: Empirical evidence suggests that even the most competitive markets are not strictly efficient. Price histories can be used to predict near future returns with a probability better than random chance. Many markets can be considered as favorable games , in the sense that there is a small probabilistic edge that smart speculators can exploit. We propose to identify this probability using conditional entropy concept. A perfect random walk has this entropy maximized, and departure from the maximal value represents a price history's predictability. We propose that market participants should be divided into two categories: producers and speculators. The former provides the negative entropy into the price, upon which the latter feed. We show that the residual negative entropy can never be arbitraged away: infinite arbitrage capital is needed to make the price a perfect random walk.