Posts tagged ‘Benoit Mendelbrot’

Efficient Market Theory’s Demise: Where do we go from here?

By , 25 July, 2009, No Comment

Mendelbrot had the problem pegged long ago, chaos and randomness…there has been no real explanations because a degree of randomness exists in the market and it is difficult to account for irrational behavior, or market noise.

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Emini Trading: Do you have style?

By , 22 July, 2009, 1 Comment

I think before anyone embarks upon serious study of trading, then trying to make a living at trading, he/she ought consider the style of trading that best fits their personality.  Unfortunately, the term “trader” means a lot of things and encompasses a wide range of trading styles and methodologies.   My personal style of trading reflects my personality, I like immediate gratification and results, so I am a scalper.

So what is a scalper?

Most scalpers, especially the scalpers who trade the eminis, seek to exploit the natural rhythm of the market and carve out small gains on each trade.  My goal is often 12 ticks, though that can change depending upon the mood of the market and an indicator I used (and have written a post about) called the Average True Range.  My trades seldom last more than 10 or 15 minutes and I exit.  I never carry positions overnight.  My account is trade free at the end of the trading session, or at least, the period of time I am trading.

I scalp because it suits my personality.  I like the fast paced action and the lack of dependence on intermediate term prognostications on the direction of the market.  Some scalpers, seek to exploit the big/ask disparities in the market, though that is never my goal.  Scalpers need to implement strict money management guidelines in their trading, and never risk more than 5% of their capital on a given trade.  There are a host of traits scalpers use, and those traits even vary from scalp trader to scalp trader.  The important thing to remember in scalping is that I am looking for very short term moves in the market to exploit, and I do not attempt to predict any overall direction of the market as a whole.  I am interested in certain moves in very specific contracts.  The market as a whole does not interest me and, generally speaking, I don’t pay much attention to overall market conditions.  I trade the chart I am looking at, not the news, not the economy, just the chart before me.

Swing traders are a different matter, though.

Swing traders are really fundamental traders who hold their positions longer than a single day. Most fundamentalists are actually swing traders since changes in corporate fundamentals generally require several days or even weeks to produce a price movement sufficient enough for the trader to claim a reasonable profit.  The important difference between a swing trader and a scalper are basic: A swing trader has a notion or idea which way the market is going to move, or which way an individual stock is going to move, and invests based upon his belief.  Swing traders usually identify a specific characteristic or event in the market and trade based upon this theory.   I should point out that though many swing traders are interested in market and stock fundamentals, there is also a field of swing trading that invest based solely on technical trading.  Oscillators, Gann lines, Dow theory….there are scads of theories that swing trader may implement to ascertain the timing and direction of the trades they choose to execute.

Technical Traders, Fundamental Traders and Efficient Market Traders.

There is scant space in this post to cover the myriad of styles these three titles cover.  I should also point out that there is often very little agreement upon methodology by the three trading camps.  Each lays claim to correctness, though I incorporate parts of all three trading styles into my personal trading style.  I will devote some posts in the future to contrasting the mindset of each of these trading theories.

The point here is a basic one, a trader ought to decide who and what he is and what style he will implement in his trading activities.  This decision is usually gained through extensive reading and trading experience.  There are some great books written on each of these trading styles, and all traders out to consider spending some time reading about the great theorists of trading and the style and rationale they employed to reach the conclusions they write about.

Some suggested reading would include:

Dr. Burton Malkiel, “A Random Walk Down Wall Street”  (efficient market theory)

Benjamin Graham and David Dodd, “Security Analysis”  (value investing, fundamental investing)

Benjamin Graham, “The Intelligent Investor”  (value investing, fundamental investing)

John Murphy, “Technical Analysis of Financial Markets” (technical trading)

J. Welles Wilder, “New Strategies in Technical Analysis” (technical trading)

Martin Pring, “Introduction to Technical Analysis” (technical trading)

Dr. Bill Williams, “Trading Chaos” (chaos and fractal theory)

Benoit Mendalbrot “The Misbehavior of Markets”

All of these fine books will provide you with a great theoretical background to begin your journey as a trader.  I have dog eared copies of each of the books, and often refer back to them to refresh my own knowledge base.

So read, trade, experiment…then find the style of trading with which you can succeed.  As always, best of luck trading.

Efficient Market Theory in Practice: How do you account for Long Tails?

By , 12 June, 2009, 3 Comments

I was reading an interesting blog post yesterday on Falkenblog that seemed to defend, in part, efficient market theory. One of the most basic tenets of efficient market theory is the assumption of investors as rational individuals. Further, this rationality is a function of the dissemination of information in our society so that all is known about a certain stock or equity instrument. The conclusion, then, is that the market efficiently distills this information, via the rational persons buying and selling of certain stocks.

Twenty five years in the stock business long ago dispelled any notion I learned in college that investors are anything close to rational, though the law of large numbers would seem to apply in that the more individuals participating in an individual issue the more likely the issue is likely to be priced properly. But history has, again and again, made it apparent that rational investors are a scarce commodity. Whether it be tulips, dot.com IPOs or houses, we are NOT rational, we are irrational. Lemming-like.

Mendelbrot theorized in “The Misbehavior of Markets” that long tails exist along any dispersion curve. With that statement he infers that catastrophic or unique events cannot be nearly encapsulated in any market theory for the exact opposite reason efficient theory draws its premise: Investors are rational.

For example, the premise during the dot.com bubble was something like this: things besides information can be efficiently distributed over the internet. I can remember looking at the business model for a dry dog food distribution operation and wondering how in the world a rational man could believe such a business model could work. It didn’t, even though the initial IPO skyrocketed, irrationally, to dizzying heights in early weeks of trading. And no the dot.com IPOs are resting in peace, after relieving millions of rational investors of their money.

Is the housing bubble any different? Well, maybe a little, as there was an overriding greed component to this bubble. Which brings me to my point: Investors aren’t rational, they’re greedy. Now don’t think for a second I believe greed is a bad thing, for it is greed, or the desire to earn a higher rate of return, that fuels capitalism. But this greed component often leaves up out on Mendelbrot’s long tail, and we have to find our way out of the long tail wilderness and back to the cozy equilibrium that exists in the main Bell curve structure.

But if Efficient Market Theory and it’s CAPM component are bunk, why is it taught at the university level with the reverence afforded holy books? Well, it’s partially true, until it comes to Long Tails, and then it falls apart. Boy, economics is tough stuff

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