John's Latest Post
Book Review: The (Mis)Behavior of Markets
If you're a first time visitor, I encourage you to subscribe to the RSS feed so you don't miss anything. Thanks for visiting!
John Forman - The Essentials of Trading author
I’ve been reading a pretty interesting book over the last few weeks. It’s The (Mis)Behavior of Markets, by Benoit Mandelbrot. The author is probably best known for his work with fractals, but has been researching financial markets on and off since the 1960s. I picked up the hard copy edition during a bargain book sale after the holidays using one of the several gift cards I received, and have been reading it on my commute.
First, a warning. This is not a book that’s going to teach you how to predict the markets. If you’re looking for that kind of book, look elsewhere. In fact, if you’re looking to learn about trading or investing in the markets, this is probably not a good book for you. This is not an overly practical book in terms of providing any methods or techniques for use in your day to day trading.
The (Mis)Behavior of Markets is much more along the lines of a scholarly discussion of prices. For those with a desire to understand how prices move, this is a good book. In particular, it’s great for understanding why it is that even the supposedly best and brightest (like Long-Term Capital Management - LTCM) could get it so wrong. In short, much of what university economics and finance departments have been teaching for years is at best misleading and at worst dangerous.
I must state for the record that I have long held a less than aggreeable view toward efficient market theory, Black-Scholes, random walk, and all of that stuff. It goes back to my days as an undergraduate finance student when I just intuitively didn’t believe what I was being told and often saw the major flaws. When I started working in the markets I saw first hand how ridiculous many of the underlying assumptions behind classic financial theory really are. In The Essentials of Trading I presented some of the basic ideas, but also indicated what I saw were the major issues.
In The (Mis)Behavior of Markets Mandebrot takes on classic financial theory in a very straightfoward manner. He is extremely critical of the way economic (and by extension financial) theory has been developed and moved forward. He spends a fair amount of time explaining how the now classic theories of price movements came about, which I found interesting since I’m a bit of a history buff.
From what I understand, many of the things that I used to gripe about with my professors as being major flaws in classic finance have finally been recognized in recent years by academia as just that. This from a professor friend of mine. I don’t know whether or not things have changed in what’s being taught, though. My impression is not so much, which to me seems a major disservice.
The thing I found most interesting in the book was how all these theories have been torn apart, not just recently, but for decades. Mandelbrot and others figured out very early on that price changes do not conform to a normal bell shaped distribution. They also figured out that price changes are not independent. Those are two major capstones underlying efficient market and random walk theories and the pricing of options using Black-Scholes.
The thing that really irks me is that none of these critiques were ever presented to me in the classroom. We were just taught the same stuff that had been taught for years and years with no perspective on how research was showing major problems.
The biggest thing Mandelbrot focuses on in terms of the implications of all the errorenous assumptions is the implied risk. He points out that things like the Crash in 1987 should literally never have happened according to classic theory, and that other market shocks in recent years were also so improbable as to be beyond the reasonable expectation of classical theory. Given how many securities are priced using models based on that classical foundation, and how the commonly employed Value at Risk (VAR) calculations are similarly based, you can see how this is a major problem. Investors and institutions have been taking much more risk than they thought. This is something which once again became readily apparent last summer as the credit crises exploded.
Mandlebrot, naturally, presents a different way of looking at price movement - one founded in his fractal theories. He readily admits, however, that it is still early in its development. Much more work and research needs to be done. One cannot use anything he presents in the book to help forecast prices, though it can help to understand better how prices move, and thus by extension the risk of financial assets, which is a benefit of potentially enormous value on its own.
All in all, I would call The (Mis)Behavior of Markets a good read. It’s informative and thought provoking, but doesn’t bog the reader down in a gread deal of math and complexity (there’s an appendix for those inclined in that direction). If you are at all intellectually curious about the financial markets, this is definitely a book worth reading.
Latest Guest Post
The Great Manic Depressive: The Markets
This post was contributed by Billy Williams
The markets are a lot like a manic depressive in that there are moments of incredible euphoria and then, almost in the blink of an eye, incredible feelings of despair and hopelessness. These emotional extremes are also contagious to those who are participating in the markets and as individuals suffer these extremes they eventually reach a point where they are paralyzed into inaction just as the markets begin to turn in their favor or detriment.
When the markets are healthy and the future for the economy looks bright the market is incredibly euphoric and like a manic depressive experiences incredible highs in emotional well-being that often result in caution being thrown away while riding the incredible sense of euphoria as the markets rise ever higher. Unfortunately, as night follows day, markets will eventually go down but the investors swept up in such a strong emotion as euphoria feel too connected to its source (the market rising) to ever consider that it may be time to lock in gains or protect a position. They are blind, like addicts that cannot admit their addictions they cannot admit that now is the time to leave the market for that has become there drug of choice.
After awhile, however, as the emotional high subsides in the market and suddenly it crashes as it discounts the future of the economy which faces a slow down or recession which causes an ever increasing sense of despair and hopelessness among the investors as they hold on during every decline and hope thru every short term rally only to feel there emotional well-being crash lower as the decline continues. The markets become more and more depressed to the point of no return for the investing faithful who have been bleeding losses since the crash and, in there final act of their investing death thro, they liquidate their holdings for a fraction of what those holdings were once worth.
The last of these sellers often result in a climatic sell off resulting in sharp move down in the markets as a violent convulsion down squeezes out the last of the investors that had been holding on. The market stands at the abyss on death’s knell causing much of Wall Street and Main Street to feel the dull pain of impending death of what they have understood to be modern day capitalism. Doom and dread is everywhere….on TV, cable financial news, in the newspapers, in the classrooms, on the cover of magazines, and in every barbershop and hair salon everyone talks of the end of the markets.
Then, as the last of the sellers receive their stocks sell slips a stirring begins again in the markets. Suddenly, volume begins to pick up and a huge rally takes place but is discounted as short-covering by the short sellers. A few days later, another rally takes place on higher volume and again is ignored. New stock leaders begin to see new levels of volume pour into their shares as big institutions and money managers begin to take positions but, still, the individual investors stay away out of fear.
Over the coming months, the pessimism of Wall Street gives way to caution with all the talking heads giving glowing commentary again about the huge prospects for the economy and hot IPO’s (initial public offerings). Institutional money is still pouring into new leaders in the stock market and smaller investors begin to wonder if the rally is for real. Those that do decide they will participate but only when stocks “get a little cheaper” but they never do.
Soon, the new leaders are rocketing higher and higher while investors feel they are missing the boat and begin to buy without noticing that the general market appears to be stalling and coming under distribution. A few weeks later, as investors are now back in the market the market appears to decline again with investors caught in the crosshairs again.
This cycle is played out over and over again as the general market’s manic condition creates an emotional whirl storm that investors get caught up in and allow themselves to become victim to.
Average investors allow themselves to fall victim to this cycle of extremes because they come into the market with no plan or method to trade. They buy on tips from there brother-in-law or because a stock is reputed to be a “good company”. These are not plans or methods they are gambling.
A fundamental key to winning then is to realize that successful trading is counter-intuitive compared to how the general public approaches the markets. Having a method or system that allows you to exploit an advantage helps but, ultimately, even the greatest trading method ever devised helps no one trade successfully if they don’t realize there are certain underlying truths to making big gains in the market that are counter-intuitive to the way most people attempt to win at trading.
Now, that you can see a little how these cycles form and are repeated we will journey together to learn how not to be swept up in a tsunami of negative emotional turmoil due to unnecessary losses by following the crowd and/or our own faulty reasoning in future posts.
Trader Q&A
The following question came in yesterday concerning support &...
Here’s another question I received from a trader, in this...
This question on performance came in from a trader over the...
Trading Resources
I’ve been reading a pretty interesting book over the last...
A few new forex ETFs are starting to trade today. These new ones...
I was asked by J.D. at Get Rich Slowly to do a guest post in...
Trading Tips
Dinosaur Trader wrote a post on his blog about respecting your...
It’s a bit sad thing, and not for the delicate types, but...
Do you take trading breaks? Do you take vacations from the screens...
Trading Basics
Chris Perunna wrote Focus on You on his blog yesterday. It echos...
Do you know your trading R? Do you even know what R is? In trading...
One of the less well understood statistics in the basic daily...
 |
Latest Posts
Book Review: The (Mis)Behavior of MarketsI’ve been reading a pretty interesting book over the last few weeks. It’s...
Option Basics and StrategyI know a lot of people are interested in options and see the potential they offer...
Respecting Your Stops is Easier With Better StopsDinosaur Trader wrote a post on his blog about respecting your stops. Basically he’s...
Trading is All About YouChris Perunna wrote Focus on You on his blog yesterday. It echos a lot of what I...
New Trading Alernatives for Currency TradersA few new forex ETFs are starting to trade today. These new ones move the group...
Free Evaluation!
Trading Essentials
Best Of ..
The Secret to Trading SuccessIf you’re reading this blog post because you actually think there is some one...
The Trader’s Wish ListMy Trader’s Wish List of good books, audio and video content, and other resources...
Misunderstanding the Bid/Ask Spread in Stock TradingThis morning I came across a blog post talking about the bid/ask spread in the stock...
Ways to approach news events in your tradingA question recently came up in regards to the impact of news on trading performance....
Trading for a Living vs Trading for Wealth BuildingSomething recently came up on one of the discussion boards I visit. It’s hardly...
How much leverage to use? Wrong question!I’ve been involved in a discussion recently on the topic of leverage. The...
An Introduction to the Fixed Income MarketThis article is a basic introduction to the fixed income market. It covers the...
