Sunday, May 21, 2006

The Market is Rigged Against Human Nature

Suppose you had two traders. One--a momentum trader--became optimistic and bought the S&P 500 Index (SPY) every time it rose in price for the day; the other--a contrarian--became optimistic and bought the S&P 500 Index (SPY) every time it declined in price for the day. Each trader held positions three days. What would be their return?

Since January, 1996 (N = 2584 trading days), the momentum trader would have an average return per trade of .01% (725 up, 617 down). The contrarian's average return would be .20% (679 up, 563 down). The trader who bought at the end of *every* day and held three days would have had a return of .10%.

In other words, simply by buying after a down day, the contrarian would have doubled the average return in the market.

By buying after an up day, the momentum trader severely underperformed the market.

Now you know why overconfidence in trading is the greatest pitfall of all. The market is rigged against human nature: getting excited after a rise and discouraged after a decline ensures that traders are on the wrong side of markets.

11 comments:

John Wheatcroft said...

Great post - I hope a lot of traders and wannabe traders read it and understand the message.

Brett Steenbarger, Ph.D. said...

Thanks, John. Back in the day, I remember Joe Granville saying, "If it's obvious, it's obviously wrong." There's some truth in that, obviously!

Brett

Paulo de León said...

I notice something different in the ES market this week. The No. of bid and offer contracts in the market depht levels decrease significantly. On avg. each level registered at least 1,500 to 2,000 lots depending on the hour of the day, this week each levels stand between 600 to 1,000.
However, this weeks the ES registered way above avg. volume, and on wednesday we have an all time volume high in ES.
How can you consolidate more volume less market depth?....

Brett Steenbarger, Ph.D. said...

Hi Paulo,

Much of what had appeared as Market Depth was the result of a few locals who would use size in the book to bully the market. A great deal of this size never traded--the orders would be pulled from the book before they were hit. Now, with more volatility, no one wants thousands of contracts in the book, because they have a higher likelihood of getting hit. One of the problems that has affected market makers is that the volume that appears in the book is no longer correlated with the volume that actually trades, because of the frequency with which orders are pulled.

Brett

procol said...

I noticed this reduced size also, and you will also observe a marked increase in 'one way' swings.

That is, price ramping 3/4 to 1 point within seconds, also related to the reduced size.

Not sure whether a decreased b/a size in the major s&p 500 stocks is the cause of this , or simply a lack of bluffing, as was mentioned.

Brett Steenbarger, Ph.D. said...

Yes, Procol, I think you have an excellent observation re: how the order book changes as a function of market volatility (which, in turn, is a function of *who* is active in the market). That is *very* important information for the scalper, but is also relevant to anyone who is trying to execute at the best possible prices.

Brett

yinTrader said...

I refer to your findings on contrarian move.

Last Friday nite 2 June 06 (Singapore), or morning EST, I traded in S&P500 on e-mini Futures.

Just before the US figures were out, I wanted to put out 2 Stop orders, ie Buy Stop and Sell Stop for S&P e-mini but my trading platform froze.

So by the time the news came out,and fiddling with the platform, I was filled in 1 buy lot at 1286.25. I put in a too tight Stop sell loss at 1.283.75 and was stopped out within a short time, with a loss of over USD100.

Disheartened, I was about to call it a day.

Towards midnight, there was a good signal entry to buy. Decided not to give up easily, I bought at market 1 lot at 1284, putting a better spread of Stop Sell at 1277.75, and a target order at Sell 1290.75, just in case I fell asleep , by 3.30 am Sing time or 2.30pm EST.

Before closing of market, I managed to wake up and seeing the volatility, I decided to exit at market price ie 1284 level. My platform froze again and I had to log out and log in again.

By default, I finally exit at 1289.5 - which not only wiped my first trade loss but gave me a net profit of USD150.

It pays not to wallow in self-pity but to go forward again, when the market comes to you.

This is what I understand about your point :market being rigged against human nature.

Brett Steenbarger, Ph.D. said...

Hi,

Frozen platforms, equipment failure, and and Internet connection problems are some of my greatest concerns in day to day trading. Which is why I have redundant brokers, online connections, computers, and execution platforms. Having orders in the book before a big number and having the screen freeze has to rank right up there as one of life's more stressful situations! Thanks for the note--

Brett

Michele said...

I've been wrestling with the issue o system reliability for some time now, with limited success. At a minimum, one would want two computers, each with a UPS to guard against power outages. However, this still leaves one vulnerable to lightning strikes, which can be a daily occurrence here in Florida in the summer. On the connectivity side, you might think that you're safe if you have cable and a separate DSL line. That's good - until some contractor digs up the phone and cable lines with a backhoe. A satellite Internet connection avoids that problem but leaves you vulnerable in the face of ice storms (like we see in upstate New York) that can coat your dish and bring down phone lines. True redundancy that avoids single point of failure problems is actually fairly difficult to achieve. And at some point the expense and complexity of all this will outweigh the probable losses a failure might incur. Unless you trade in a league I'm not part of :-)

Brett Steenbarger, Ph.D. said...

Hi Michele,

The professional trading firms I work with typically have direct connections to the exchanges, backed up by internet and phone. That doesn't necessarily enable you to continue trading if the direct lines go down, but it's enough to get you out of positions. I have two internet providers (cable and phone) and two brokers; that's worked for me...so far...

Brett

Ken said...

Be very careful here though. This may be true for the specific time period mentioned (3 days) but for longer time periods research has shown that the big winners in the market are those who buy strength and sell weakness. The S&P itself is a managed index which buys strong stocks and dumps weak stocks and thats what keeps it moving higher over the long run.