Wednesday, January 04, 2017

A Deadly Bias That Affects Active Traders

One of the most common biases I observe among short-term traders is one that looks for market movement.  Because most short-term traders trade directional moves, they naturally hope for moves that extend, that give the most potential profits.  A market that moves is a "good" market; one that offers little movement is "choppy" and poor for trading.  If we think of the dynamics of realized and implied volatility in the stock market, we can see that this long volatility bias is actually a bearish bias.  When it comes to market movement, the elevator moves more quickly in the downward direction than upward.  Not surprisingly, many traders root for reversals of market gains, hoping to profit from quick directional movement and the volatility of the downside.

This bearish bias can be deadly, as it leads traders to ignore the actual flow of supply and demand and color their market perceptions with their preferences.  More than once, I've heard traders complain that a move higher was "fake" or "manipulated" or caused by "machines", thus discounting what the market was doing and instead sticking with a bias.

A good general rule is that the very largest market participants--think sovereign wealth funds, pension funds, asset managers, etc.--take the longest time horizons.  Their sheer size leads them to be investors, not just traders.  With that increased holding period comes an increased focus on fundamentals.  Global growth rates matter little for a 10-minute trade, but matter quite a bit for a 10-year investment.  The day trader doesn't have to worry if we're entering a deflationary or inflationary environment.  That same issue may shape much of an investor's holdings.

This is why it's helpful for even short-term traders to be aware of fundamentals and the big pictures that shape the behavior of investors.  If the big picture is favorable, oversold situations are likely to be viewed as value.  That will impact market trend and volatility, which percolate down to the shortest time frames.  

I hear considerable frustration from traders lately.  Some did not profit from the recent bull move to new highs and insist it must be reversed.  Some are not happy with the U.S. Presidential election results and look for things to collapse.  Some are just tired of sub-20 VIX markets.  A great check on frustration is to actually look at the economic data and trends that the largest market participants look at.  A site that curates this information effectively is A Dash of Insight.  If you check out the most recent posting, you'll see a summary of the latest economic data releases, including which ones are showing increased strength and which ones are signaling weakness.  You'll also see a host of macroeconomic indicators that track the likelihood of recession.  Over time, you can gain perspective on whether the economic picture is becoming more or less favorable--and that provides a window on how institutional participants are likely to respond when they see stock market strength and weakness.

I think you'll be surprised when you look at the data.  A fresh look at information is a great antidote for confirmation bias and a great prod for open mindedness.  The best traders look for data that disconfirm their leanings; that is what helps them update views and not get locked in stale ones.

Further Reading:  Creativity and Innovation in Trading