Saturday, September 17, 2016

Trading and the butterfly effect

Have you ever considered how you could come across two or more setups that are seemingly identical, and yet one moves in one particular direction, and another moves in a totally haphazard manner, and possibly start to move in completely the opposite direction?

Mark Douglas gave the best answer to this question in Trading in the Zone. Basically his explanation was as follows:

Every moment in the market is unique, and what happens is dependent upon the traders actively involved in a stock or instrument, their beliefs and their buying and selling at that point in time.

So, for example, take a chart set up on a stock index. There will be a number of market participants who will act upon what they are seeing (such as a certain price pattern), which will cause a particular price movement.

A few weeks later, an identical set up could appear in the same index. This in itself is extremely unlikely - there will always be minor variations, but we will assume here that the same basic 'pattern' or set up in the price action is apparent.

Now, for the same subsequent price movement to occur, the same market participants (who have the same beliefs) must interact in the market with the same buying and selling activity, in the same order, to create the same price movement.

Now, given that there may be tens of thousands of traders all looking at the same chart or information, ready to act on what they see, how often is that going to happen?

It only takes one trader to make a different decision, or to buy or sell at a different stage in the process of that price movement, and that could change the whole nature of the price move, which may impact on other market participant's buying and selling decisions or activity.

One particular example of a certain price pattern may generate a big price move. An identical set up a few weeks later may see the same attempted move quickly stall and reverse, because of the change in the composition of the market participants who are trading that index, their beliefs and their own buying and selling activity.

And of course, at any different point in time there will be external factors or catalysts which come and go, and could influence market participants and their actions - such as overall market sentiment or economic news.

This is why trading is a game of odds or probabilities, and not absolutes or certainties.

In effect, this is the trading equivalent of the 'butterfly effect'. We often hear of this in terms of predicting the weather - how a butterfly flapping its wings in South America may influence the weather patterns in Europe several weeks later. 

What Mark Douglas was talking about is the same principle.

One New York-based trader's interaction with the market may influence someone based in Frankfurt, or London, or anywhere else. In the financial market's case though, the patterns and subsequent reactions to them could change at any second.

Any one trader or investor and their interaction with the market therefore has the potential to start a change in the perception of how price may or may not move - thereby directly influencing any other buying or selling activity.

It took me a couple of reads of Trading in the Zone to truly 'get' this, but once I did, it made complete sense to me. And when you think about it, its obvious.

Understanding this gives you the freedom to accept that you cannot predict what may or may not happen with any level of certainty. Therefore, you need to ensure you only think in terms of probabilities, and plan for this in your trade execution, by ensuring you don't take excessive risk, and also accepting that you will incur losses - even on the best setups which match your criteria, and may be identical to setups which end up generating profitable trades.

4 comments:

  1. Thanks for another thoughtful article. I'm familiar with the Mark Douglas school of thought regarding every moment in the market being random and unique. But I hadn't thought about it in terms of the butterfly effect. It's a great analogy you've come up with and one that will help me further internalize this important principle. Thanks again!

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  2. Agree 100% with Jay's comments!

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