The unintuitive thing about the stock market is that you are not trying to predict a system unrelated to yourself. But you are trying to predict other people's behavior. People who are just like you.
So when you notice a pattern - say "Stock S trades lower on Tuesdays and higher on Fridays", what do you do?
Do you buy on Tuesday to exploit the pattern?
Or do you buy on Friday because you are not a unique snowflake and others will notice the same historical pattern and therefore reverse it in the future?
There is no way to decide. Because even if you see long-running patterns in the history of the stock market, those patterns might have reverted just at that moment when people like you noticed them.
This holds for all patterns. Even if they are as complex as the ones described in the article.
> Or do you buy on Friday because you are not a unique snowflake and others will notice the same historical pattern and therefore reverse it in the future?
Well, as you said, you're not a unique snowflake. Many people will make that extra thinking step too.
You can try and make another step, try to account for people aiming for the trend reversal. But you're not a unique snowflake - some people will think about it too, and account for those people the same way.
If this starts to look like infinite series, it is, and it converges to something, and I suppose there are some mathematical truths to be said about it. But the practical truth is, any pattern that becomes noticed will not end up reversed. It will be driven back down to random noise. This is the anti-inductive nature of phenomena like stock markets: once a pattern becomes known, it disappears.
What you describe is similar to what beagle3 described. A world where patterns exist and slowly fade out.
But that is not the reality of the stock market. See my reply to beagle3 for two ways to counter this view.
Specifically to your point that patterns exist but do not reverse: Then one could make money by just trading against the pattern. If no "punishment" comes down the line in form of a reversed pattern, there would be no risk.
The simplest example would be a hypothetical irrational bull market euphoria. More and more new investors come in under the assumption "OMG! Every day the prices are higher than yesterday!". If that pattern would not reverse, there could not be an "irrational euphoria" because prices would either rise forever or stay on the highest level. So it would be only rational to join the choir. Much to gain, nothing to lose.
ya so notice the pattern before anyone else and extract money by filling the inefficiency. this isn't a profound insight, the nature of alpha is that it's temporary and limited. doesn't mean it doesn't exist and you can't take advantage of it - as long as you're better than everyone else (faster, smarter, cheat-ier). tbh it's just like entrepreneurship - starting a business will attract competitors. but you can just outcompete them.
You don't know if "anyone else" already noticed the pattern. That does not reflect in the historical prices you can see. It will reflect in future prices which you can't see. And waiting for those does not help either. You are always at square one. Because others are sitting somewhere, watching the data and thinking about it just like you.
They don’t all notice a long time pattern at exactly the same time. Alpha decays over time as more people notice and exploit it, or the market slowly changes.
When alpha disappears overnight, it’s almost surely for reasons unrelated to other statistical event players - e.g. a tectonic shift caused by some bankruptcy, interest change, political decision, etc.
However, many traders do not know how to properly model and backtest. It works on backtest, fails in the real world, and they explain that “alpha is gone” when in reality it wasn’t there to begin with - it’s just that their backtest was bad - usually overfit or unrealistic assumptions.
You describe a world where you can watch the pattern slowly fade out and stop when it is gone.
But in reality, there is noise.
Say you start exploiting the pattern. You buy on Tuesday and sell on Friday. After 3 weeks of doing so, you lost money every time. Is the pattern gone? Or is this just statistical noise? Should you stop or plow through? You don't know.
Another way to look at it: We would have the exact same discussions if stocks prices were just random walk series.
To make a point in favor of pattern arbitrage, one would have to show that stocks differ from random walk series. Enough to be worth trading against this difference. As far as I know, nobody ever came up with a good argument in favor of this assumption.
The way to tell signal from noise is with enough statistics. That’s one benefit HFT has over “traditional” trading - it gives you thousands of data points per day. The other way to quickly get thousands of data points per day is to trade slowly but across many assets (which is a much harder game, granted).
Either way, if you know what you are doing, your backtest should also give you a good idea of the variance, and that should tell you if a 3 week loss is statistically probable or not. Personally, I guess I’d stay away from such strategies - I’d prefer a much lower alpha with much lower variance - so that I have effective feedback from the market.
Some firms, e.g. RenTech and Virtu , manage to have very consistent alpha. You haven’t seen a good argument because people who make money don’t care to convince you.
> You describe a world where you can watch the pattern slowly fade out and stop when it is gone.
Yes, this is a phenomenon that happens very often during alpha research. You discover something that is decaying already, and you join the wagon until there is no anomaly to correct anymore, at which point you should have found other wagons to join. It's an eternal race of finding new alphas while your previous ones decay.
The rest of your argument doesn't really make sense. You seem to be just against any form of statistical inference.
"Alpha" is called like that on purpose because it is _not_ noise anymore. If you regress it against your benchmark, you should definitely see a difference between alpha and epsilon, given you have enough points to reach statistical significance.
> one would have to show that stocks differ from random walk series
There is easily 40 years of litterature on the subject. You can convince yourself in 5m by running a PCA of stocks returns against beta, sector and country. Then you can run a second round of PCA of these residualized returns against momentum, size, value and quality. Quants funds find alpha against these latter residualized returns.
> So when you notice a pattern - say "Stock S trades lower on Tuesdays and higher on Fridays", what do you do?
Do you buy on Tuesday to exploit the pattern?
Or do you buy on Friday because you are not a unique snowflake and others will notice the same historical pattern and therefore reverse it in the future?
Why would you expect it to reverse?
If anything I’d expect the pattern to disappear once detects and arbed away.
I can’t see how you’d think the pattern would reverse itself.
I'm familiar with Iocaine Powder. The fact that it won an internet Roshambo competition doesn't mean that it's the dominant strategy. If the opponent knows what move Iocaine Powder is going to play, the structure of Roshambo tells us that there's always a move that beats it. If it is not performing well, then it falls back to completely random. Completely random is a perfectly reasonable thing if you're in a Roshambo contest, not so much if you're trading money because transaction fees will eat your profits.
That is the reason why most big quant hedge funds look for ghost patterns. Patterns that are not obviously at the first sight and which can be (hopefully) solely mined until the pattern disappears.
To catch onto obvious patterns you have to be not really fast but nano-microseconds fast, otherwise in a blink of an eye the price is already too high to jump in.
I imagine that if one has enough capital to fully arbitrage an opportunity, it is possible to
A) capture the entire available upside
B) estimate how large that opportunity might be, and not attempt to over-stoke it.
C) by capturing the entire opportunity, prevent the signal from being visible to the broader market. The only sign that a need is being met could be trade-volume rather than price movement.
That's why most quant hedge funds only have limited amount of aum. Most their strategies consist of a large amount of low volume trades. Low volume to prevent the ghost pattern being visible to others. This is especially true for non hft firms that hold positions in a much longer interval (minutes - hours - days). But this is untrue of course for lets say a big macro hedge fund that throws a hundred million dollars into a currency trade.
I totally agree on all three points and I even think that a certain amount of capital, opportunity related (not fees etc.), is not even needed to mine a pattern. Because according to the ones statistics and research the actually existing pattern should appear anyway.
Also you can decide by looking at what the market is pricing in relative to what the probabilities are (in your mind) - one might be a more scalable trade whereas it could be that the latter one was super cheap so you take a punt on it (e.g. let's say the implied volatility is far too low)
According to your theory, would you also explain Bitcoin's future as the halving event is approaching. Everybody knows the halving will happen in around april next year. Since everybody knows (everybody will notice the same historical pattern), do you think it will be reversed ?
In any liquid enough market one should assume significant known future events are priced in and the current price reflects them already. Are bitcoin markets 'liquid enough'? I don't know. And even when something is priced in, you can still expect prices to change a bit after events, because going from X% likelihood of happening to has happened is a difference.
Generally speaking though, the price of bitcoin will probably change much less because of the halving than someone might expect.
People have been talking about Bitcoin as an inflation hedge for a long time, despite the fact that Bitcoin has been printing money at a significant rate. Bitcoin would have been a lot lower valued if it didn't already have the scheduled halvings built into its price.
In an arbitrage trade you might even want to put more money in if it goes against you - spread widens, so you can make more money as long as you are right.
> Do you buy on Tuesday to exploit the pattern?
> Or do you buy on Friday because you are not a unique snowflake and others will notice the same historical pattern and therefore reverse it in the future?
Well you would typically do both, as 2 separate signals, or even more as time horizons widen.
This modelling is part of the "physics" side of quantitative finance, and often revolves around the use of oscillators and other dynamic systems.
Try to picture the pattern of voltage oscillations when you suddenly release a switch. Price often converge in exactly the same fashion. You can create a whole convincing analogy between voltage oscillations, capacitors, resistors, and actors of the stock market.
The way to see it is that the price will most likely oscillate around the consensus price, until it more or less settles. The first part of the oscillation, right at the point of publication, will create a momentum from the current price, which will then overshoot to create a reversal, which will then overshoot to create an other momentum, etc. Each time a cycle of momentum / reversal switches, the amount of overshoot diminishes and the time horizon of correction increases.
To illustrate, let's imagine a news on ACME Corp, currently trading at $10, just got released saying that their earnings will be above expectations.
- In the first 30 seconds a strong momentum will drive the stock price from $10 to say $15.
- After the initial 30 seconds of momentum, the price will have most likely overshoot. Many factors will lead to this overshoot: abuse of market orders on news to get executed faster, imperfect execution of limit orders, genuine over-excitement from participants, delayed basket comparison computations, etc.
- From the 30th second to say the 15th minute, the overshoot will revert from $15 to say $13. People will compare ACME Corp to its sector, country and beta, they will realize it's overvalued and short it.
- After 15m the reversal will have overshoot to $13 and a new momentum will arrive until the end of the day, settling in on close at $14.
- After a week the original daily momentum will revert to $13.5 as slower mid-freqs catchup and agree on a more precise consensus price.
So when you notice a pattern - say "Stock S trades lower on Tuesdays and higher on Fridays", what do you do?
Do you buy on Tuesday to exploit the pattern?
Or do you buy on Friday because you are not a unique snowflake and others will notice the same historical pattern and therefore reverse it in the future?
There is no way to decide. Because even if you see long-running patterns in the history of the stock market, those patterns might have reverted just at that moment when people like you noticed them.
This holds for all patterns. Even if they are as complex as the ones described in the article.