Readers of “A Dash” know that we are not attempting to describe or explain every zig and zag of the market. It is not that we lack opinions; it is just not our purpose. By way of contrast, each day we write a market commentary for our clients on our private blog. For our investors, we discuss what is currently happening with special attention to the positions we own.
Background: Explaining the Daily Market
This daily exercise puts us in the position of the journalist, looking at the blank page and needing to write something intelligent to describe market action. The journalist has no choice. Something must be written. Tomorrow’s readers need an definitive explanation.
We have a choice. We frequently observe that market moves were basically random noise. Often we disagree with what we know will be the headline story in the next day’s papers. [For today -- Oil prices went up, despite OPEC supply increases. There was a lot of futures buying driving a low-volume rally. Some big player(s) wanted more exposure. There is no real explanation. Others will cite a "rethinking" of Fed moves. Yada, yada.]
The Outcome Bias
One of the many useful contributions of the study of cognitive biases is the outcome bias. When one starts with knowledge of the result, it is easy to find explanations and easier to conclude that one’s own decisions would have been perfect. There are strong psychological studies of this effect.
My non-trader friends often observe, after a volatile market day, how wonderful it must have been for traders. It shows how little they understand. The volatile day provides potential for a wide variation in results. It all depends on how one was positioned going in. For those with each position there will be successes and failures.
Long Premium. This means that you own options which gain deltas (your favorable position gets bigger) as the underlying stocks move higher and lose deltas as the stocks move lower. The trader takes “scalps” by selling short stock on the rally and buying it on the decline. Even this trader may kick himself for “selling too soon” or not guessing the trading range correctly. The actual traders with this position will do many different things, some getting the optimum result by selling at the top. Others might wind up losers if they do not trade at all, expecting a big run rather than a trading range.
Long the Underlying. Your stock (or index) rallies. You get a big upward move. Did you sell anything? If you did, you can buy back lower. If not, you have some explaining to do, since experienced traders always sell something into rallies.
Short the Underlying. Your stock (or index) rallies in your face. Your losses are mounting. Do you throw in the towel? Do you add to positions? Either could be correct, but today, only one decision was right. As in the other cases, some of those with this position make each decision. There are many different stories, including those selling at the top. Every trade has two sides.
Short the Premium. This is the toughest. Suppose that a trader decided after last Friday’s employment report to sell some index calls, expecting them to expire worthless. A big rally like today’s can cause calls to explode in value, making the position much larger than the original planned size. Should the trader bail out? We know from experience that every trader has a price where he gives up. If the trader does not have this price, his backer or clearing firm does. Brett Steenbarger has a great discussion of trader fear, and this is one of the causes. [searching for Adam Warner's recent great article on this topic. Link to be added and help sought.] Our experience with traders is that original position size is often too large, based upon what the trader hopes to gain, rather than the risk of loss.
In tournament bridge circles (a group including many leading traders and investors) we often give a problem “on a napkin.” It is called this because it involves card play, and is written down at dinner on a handy piece of paper. Sometimes there is an obvious way to play the hand — clearly best via expert analysis. The person posing the problem hopes to get confirmation for his (losing) decision or admiration for his brilliancy from his fellow experts. The problem is that some of those getting the problem may try (consciously or subconsciously) to gain acclaim from dinner companions by finding the winning answer on the particular deal. That respondent may choose an anti-percentage action, just because of the problem setting.
This would be an interesting trader experiment. We are not going to summarize the factors leading to today’s trading, since the information is readily available. Instead, let us imagine an experiment. Perhaps Brett Steenbarger, who works daily with traders, or Scott Rothbort, who uses innovative methods in his classes, will give this experiment some thought and find an implementation.
Take a day like today, and some other big market moves. Provide whatever information might seem to be relevant — charts, economic fundamentals, earnings stories, breaking news — to everyone in the test panel.
Tell them the news – in advance!
Each participant gets to predict the market outcome knowing the news in advance. The experiment could include a variety of situational examples with different facts.
The key point is one of our recurring themes — the difficulty in predicting unlikely events.
We would expect a range of outcomes with very few coming close to maximizing the result. We suspect that those with the “wrong” positions would do the worst, reacting to fear. Those with the “right” positions would not come close to optimizing the result. This expectation is based upon experience. We have been there.
Individual investors who understand the advantage of staying with the normal odds — and not trying to predict extreme outcomes — can gain a significant advantage. For the individual investor it comes down to understanding the difference in time frames and not being frightened by volatility.
Last 5 posts by Jeffrey Miller
- The Fed as a Fig Leaf - May 23rd, 2013
- Weighing the Week Ahead: Are You Ready for Some Fedspeak? - May 18th, 2013
- A Flaw in the Tepper Analysis - May 14th, 2013
- Weighing the Week Ahead: Are Consumers Ready to Buy? What about Housing? - May 11th, 2013
- Earnings Season and the Dog that Did Not Bark - May 8th, 2013
About Jeffrey Miller (http://www.oldprof.typepad.com)
Jeffrey A. Miller, Ph.D. is a former college professor with a hands-on, real world attitude. His quantitative modeling helped inform state and local officials in Wisconsin for more than a decade. A Public Policy analyst, he taught advanced research methods at the University of Wisconsin, and analyzed many issues related to state tax policy.
In 1987 Jeff began work for market makers at the Chicago Board Options Exchange. His approach included finding anomalies in the standard option pricing models and developing new forecasting techniques. Merging these quantitative techniques with specific company analysis, Jeff also generated trading ideas from sell-side analyst reports.
Through his years of experience in trading options, futures and equities, Jeff has come to be regarded as an expert in interpreting the effect of news on the markets and individual stocks. Jeff has served as a forensic expert in several cases involving such issues. He has also written a series of papers on investment management, describing both quantitative methods and those related to behavioral economics.