## Tuesday, September 05, 2006

### Patterns in Minds and Markets

What seems significant can be purely random, and sometimes what seems random is quite significant.

An interesting discussion on a mailing list rekindled my memory of having tried a little experiment. I went to a website that performs runs tests on number sequences to test whether or not those sequences are random. I did my best to construct a random series of numbers, moving my fingers at will around the keyboard. The test found that the number sequence I entered showed probable evidence against randomness. In fact, my best effort at being random was significant at the .03 level.

Later, I entered the daily price changes for the S&P 500 Index for August, 2006, a period of seeming positive trend. Nope. Little or no evidence against randomness.

It turns out that human beings are quite patterned in their efforts to produce randomness. Their random sequences have fewer runs of numbers than are found in true randomness. If we're tossing a fair coin, for example, we should get runs of five consecutive heads about 3% of the time. Interestingly, my attempt to generate a random sequence with 1's and 2's didn't even have runs of three (which should occur about 12.5% of the time). It was statistically significant at the .01 level!

What does this mean for trading? Quite simply, unaided human judgment is poorly positioned to detect what is significant and what is random. We see a string of rising prices and conclude it must be a "trend". Intellectually, we know that any pattern of six dots positioned on a piece of graph paper must form certain shapes occasionally as a matter of chance. Nevertheless, we persist on finding meaning in such "chart patterns".

We assume that sequences are significant and that randomness lacks sequence. And that is all wrong.

It's also the source of many psychological problems in trading. When we have sequences of winning trades, we view this as significant and conclude that we have skill and a hot hand. Not infrequently that affects our next series of trades. Conversely, when we have sequences of losing trades, we imbue that with similar significance and lament our slump. Often our next trades reflect our diminished confidence.

We'll buy a trading system after it's had a hot period--and then get rid of it after a series of flat or losing periods. After extended drops, traders reliably withdraw their money from Rydex funds and their equivalents; bullish sentiment rises with a rising market. The human mind seems wired to detect patterns, and even when we try to be random, we find ourselves patterned.

When asked about his cigar as a possible symbol of a sexual organ, Freud replied, "Sometimes a cigar is just a cigar."

And sometimes a pattern is just a pattern.

Our ability to detect patterns is at once the source of trading skill--and weakness.

Hi Brett

"a pattern is just a pattern"

BUT a delta footprint tells us more; however,detection of patterns is very elusive!

Brett Steenbarger, Ph.D. said...

Yes, and sometimes--even with the best tools--we can read patterns into short-term market noise. The best patterns, I find, are ones that set up over time and that fit with my overall market research.

Brett

Leisa said...

What a treat to find this blog--through the 24/7 blog, and I found them through bill cara's blog. Thank you for providing this quality content. I clicked on the "dark side" of the Lebanon. I have shivers.

Brett Steenbarger, Ph.D. said...

Thank you, Leisa; I appreciate the feedback. I'll be scouring websites for confirmation of that unsettling Debka.com report.

Brett

Krasimir said...

Hi Brett, excellent article. I think there is a tight connection between statistics and trading psychology. When one trades statistically significant patterns, then he/she feels more confident. For example, its' good to know that a traded systems has a positive expectancy /avg wins > avg. losses/; to know the system's streaks and its dependancies. Isn't that psychological. Hence, one could implement differnt money management techniques, such as trading the equity curve, etc. which is also psychological. In summary, I would say, that everything is psychology and everyone has to be aware of his/her own mind patterns and how they 'interpret' market patterns...

Brett Steenbarger, Ph.D. said...

You raise an excellent point: testing out a pattern empirically does indeed help a trader feel confident in it. Similarly, testing out a pattern in your own experience by trading it in simulation mode is a confidence builder. Sometimes traders ask me why they're having problems feeling confident in their trading, and then I find out they've never put their methods to the test. Why *should* they feel confident?!

Brett

Krasimir said...

Hi Brett,

Yes, I think that backtesting and forwardtesting (sim trading) are excellent confidence builders, but only to the extend that they provide you with the assurance that you trade a profitable trading system and market that "speaks" to you. In other words, you will be confident in your system and the market you trade, hence, as you say in your Diagnosing the Trader article in SFO magazine you would solve the first two types of problems: 1)chornical trading problems and 2)situational trading problems. Do you think that this could solve the last two problems: 3)chronical psychological problems and 4)situational psychological problems?

Maybe I am wrong. I say the above from my point of view and from what I have experienced as a trader. I'm still learning and waiting for you new book...

Brett Steenbarger, Ph.D. said...

Hi Kras,

While I do think testing one's ideas can bring confidence, I don't think it can guarantee a solid psychology. There are many situational problems and chronic emotional disorders that have nothing whatever to do with trading, but that still can affect trading. Relationship difficulties are situational and can interfere with a trader's concentration and performance. Major depressive disorder has a biological component that cannot be addressed through changing one's trading.

Identifying the source of trading problems is key. Sometimes emotional disruptions of trading are caused by poor trading practice; other times they are the result of factors entirely outside of trading.

Thanks for the opportunity to clarify.

Brett