Tuesday, February 28, 2012

10 Heresies of Finance

I set a reading list for new programming hires before they ever interact with customers. OneStepRemoved's newest programmer, Jon Rackley, comes with an outstanding background in programming, but almost no market knowledge. Jon is under my wing for the next few months. My goal is to fully indoctrinate him on my market views.

One of the most useful, high level overview of trading dynamics is Benoit Mandelbrot's The (Mis)behavior of Markets. My philosophy is that before you attack a problem, you first need to understand the problem. Building trading robots is the problem that our customers face every day. One reason that many would-be automated traders fail is that they understand very little about how markets function. They try to solve a problem that they don't understand very well.

Mandelbot's "10 heresies of finance" sums up my view of markets quite well. I made Jon read the book as part of his job training because has no trading experience. If you're relatively new to markets or think it's time to step back and re-evaluate your approach, then I highly recommend this book.

The 10 heresies of finance

  1. Markets are turbulent.

  2. Markets are far more risky than the standard theories imagine. Mandelbrot does do a very good job throughout his book explaining how unpredictable and complex market behavior really is.

  3. Market timing matters greatly. Big gains and losses concentrate into small packages of time. He calls this trading time.

  4. Prices often leap, not glide. That adds to the risk.

  5. Time is flexible. Some times of day are more important than others

  6. Markets in all places and ages work alike. Human behavior never changes, even if the mood does

  7. Markets are inherently uncertain. Bubbles are inevitable. We will always be greedy

  8. Markets are deceptive.

  9. Forecasting prices may be perilous, but you can estimate the odds of future volatility

  10. In financial markets, the idea of “value” has limited value.

Jon found Mandelbrot's comparison between wind turbulence and market dynamics the most compelling part of his argument. It's conceptually difficult to accept the idea of human behavior acting like the wind. The math of the two behaviors is identical, which is somewhat difficult to accept emotionally. What I like about the argument is that it makes for a beautiful metaphor.

When a storm comes up, it's noteworthy. The average wind speed picks up. People notice that part. What everyone really notices and gossips about are the wind gusts. Staring out the window and watching the family oak tree bend a quarter way to the ground makes an impression.

Wind gusts are essentially market volatility. Events like a collapse of the euro or a surprise NFP number are the violent gusts of wind that make the jaws of traders everywhere drop to the ground. One gust begets another gust, packing themselves densely in time. Mandelbrot would reference the
increase in gusts as trading time speeding up.

If you enjoy these types of ideas, you might find our free resetting moving average indicator useful. It builds on Mandelbrot's fractal approach to markets, negating the idea of a true average. The resetting moving average tries to act as a minimum reference point by changing its period in step with market volatility.