Saturday, July 15, 2006

The Market is Wired Differently From Human Brains

Human brains are wired to think inductively. If something happens, then it happens again, and again, again, and again, we begin to perceive a regularity. We expect rainstorms to follow from dark, threatening clouds, not bright, blue skies. We've seen the pattern many times before.

It would be a strange world if hours of bright sun and blue sky increased the odds of rainfall, or if a stretch of rain suddenly reverted to brilliant, cloudless days.

Yet that is the world of the stock market. After spending time at one extreme, it is wired to revert to the opposite extreme. That means that, just when human brains expect one extreme to persist, the other one kicks in. As soon as the trader is ready to bring an umbrella to work, the sun comes out. No sooner does the trader put on suntan lotion than clouds appear and drench the poor fool.

There are all sorts of bits of wisdom about the market's tendency to reverse extremes. One trader recently reminded me that the truly great traders are bulls who buy big when the markets have made a plunge. "Yeah," I replied, "that's because they were smart enough to be in cash at the top."

It's nice to put points on the board, but it's still defense that wins Super Bowls, dude.

Quick: What's the total return of a trader who makes a 90% profit in Period One, 90% in Period Two, 90% in Period Three, and a 90% loss in Period Four? If I'm not mistaken, he's down nearly 33% on his original capital and needs a 50% gain just to return to where he started. That's where a 75% win/loss ratio will take you without risk management.

That's important, because the market is wired differently from human brains in one other respect. We're accustomed to events that are normally distributed. We expect our children to grow to a height somewhere between 4 and 7 feet, with a nice big cluster of expectations toward the middle. But if the market governed the growth of our kids, we'd have occasional clusters of offspring that were doll-sized or true giants. Three standard deviation events occur about half of one percent of the time normally, but far more often in markets.

So yes, while markets revert to their extremes, they also more often than normally push those extremes to extremes, wiping out those that rely on smug market wisdom.

Which gets us back to playing defense.

Even if your trading methods make you right 60% of the time and you trade once a day, you'll have, on average, five stretches of time in which you're wrong on four consecutive trades. Bet big on those four trades, and your winning system takes you to the poorhouse.

Just a note of caution from the same guy who tells you that over 1000 stocks made fresh 65-day lows on Friday. When that has happened since September, 2002 (N = 42), the S&P 500 (SPY) has been up 20 days later by an average of 3.59% (33 up, 9 down). That's a whole lot better than the average 20-day gain of .92% for that period as a whole (612 up, 333 down).

Of course, if you had bought that pattern in August, 1974 or October, 1987, the S&P 500 would have lost over 10% in a month's time, not one of life's kinder prospects for a leveraged trader.

Go with the odds, but make sure you can survive the odds you're wrong. Better advice than that I cannot give.