Saturday, June 04, 2016

How Language Defines Our Limits--And Our Opportunities

Many trading challenges are embedded in the language we use to describe markets.

Among the most common things I hear from traders is that markets are difficult to trade because they are "choppy" and "noisy".  What, precisely, does this mean?

A clue to the meaning is that we never hear the opposite.  When was the last time you ever observed a trader high-fiving because markets were "smooth" and "predictable"?  When have you heard someone making money attribute profits to market "noise"?

Yet another clue to the meaning is that very few traders actually measure market choppiness/noise.  It's not that noise and signal are part of an explicit trading framework; rather choppiness is used as a reason to either explain losses or to not trade at all.  From that perspective, a choppy market is one that cannot be successfully traded.  It's the market equivalent of playing in a casino where the game is severely rigged against the gambler.  Perhaps that is why so many conversations that start on the topic of market chop veer onto the topic of "algos" and their "manipulation" of markets.

As Wittgenstein observes, language captures our limits and our possibilities.  If our language describes people of a certain race or ethnicity as inferior people, we will sustain all sorts of behavioral biases against those people.  If we feel a need to trade to make a living and our language construes markets as impossibly noisy, frustration is the inevitable result.  The trader who bemoans choppy markets is really conveying the meaning, "I find this market untradable and frustrating".

The problem with such language is that it leads to no possible solution.  If I regard a class of people as worthless, I have basically blocked any potential positive interactions.  If I view markets as filled with noise, I block any efforts to identify signal.

The traders I see making money are employing language differently to make sense of frequently-changing markets.  For example, several traders I know are trading shorter-term strategies and longer-term strategies and adjusting the weighting of those based upon how markets are moving.  A good example was yesterday's trade in the ES futures.  We had early selling off the weak jobs number, but many sectors of the market displayed buying interest.  The advance-decline line was unusually strong, given the decline in the average, and we never hit a selling extreme of -800 or less in the NYSE TICK measure.  This was a useful tell that the selling was part of sector rotation, not part of a general bear/risk-off move.  Recognizing this made it much easier to take profits on short positions early in the day and not get whipsawed by the afternoon strength.

A more radical language shift is to break markets down into cycles and trends and identify when each mode is dominant.  This leads to mean reverting trades in cyclical regimes and momentum trades in trending ones.  Note here the conceptual shift: noisy markets are defined as cyclical ones.  That leads to a potentially constructive direction: identifying whether there is a dominant cycle that can be expected to continue into the immediate future.  An adaptive trader trades the market conditions that exist, not any preferred regime across the board.

My own trading has proceeded with a yet more radical shift.  I start with the idea that *only* cycles exist in financial markets.  What appear as momentum/trend and value/mean reverting periods are simply different phases of cycles that exist at varying frequencies.  It is the interplay of these longer and shorter duration cycles that creates the complexity of movement within markets.  When cycles at shorter and longer frequencies are in mean reverting mode concurrently, markets will look choppy.  When multiple cycles are aligned in up or down phases, markets will look trending.  It's all one elephant and we're the blind men feeling various parts of the animal and trying to figure out what it looks like.

A natural consequence of adopting the language of cycles is that it naturally leads to an attitude of "this too shall pass."  Indeed, if we think of multiple cycles aligning in a mean-reverting mode, that suggests that multiple cycles may be peaking or cresting.  In such a case, the periods of greatest choppiness would tend to precede the periods of greatest opportunity.

Language frames our problems and language frames our opportunity set.  I strongly suspect there are no markets devoid of opportunity; only impoverished mindsets.

Further Reading:  The Dynamics of Market Cycles