Although my primary intent with this website is to provide my own articles and videos, I do also like to link to quality material on other sites, as it’s discovered by myself or a reader. Today I’d like you to read a four part series written by Adam from SMB Training on the randomness (or not) of market price action. It’s a great series of articles. You’ll find the links down below, following some email Q&A from Aaron (YTC newsletter reader) who discovered this series.
I think you would really like this article – right up your alley.
It’s an SMB Capital post about the tendency of humans to see patterns reflecting deeper causes when they aren’t actually caused by anything and, in reality, are simply random. Anyway, SMB does a much better job than me at explaining, so I won’t steal their thunder. Hope you’re doing well!
Yeah, great article. Thanks. It reminds me of kind of where I was going with my "Support and Resistance on Composite Indices" article.
…save and then open the excel spreadsheet available from this link.* This is a random number generator which displays its output as a series of 200 price bars, and their corresponding RSI. You’ll see the rules it uses for construction of the price bars above the chart display. Press F9 as many times as you wish to see further charts, once again based on a new sequence of random numbers. (I’m not sure of the influence the programming of the excel random number function would have on validity of data – I’m operating on the assumption that it’s close enough to random).
The interesting observation from this is that random data when plotted in price chart format appear quite clearly to show characteristics of financial charts. Pressing F9 multiple times and you’ll see all kind of chart formations – trends, support & resistance, head and shoulder patterns, triangles, double tops / bottoms etc.
This is not evidence of the random walk concept. The fact that random data appears to share the same characteristics as financial charts, does not mean that financial charts are random. In fact, I’m told that when comparing plots of the standard deviation of price closes vs the same for random data, the result is quite different. Random data forms a nice normalized bell curve. The financial chart data apparently is more narrow in the body with a very wide base, indicating greater periods of consolidation which are separated by larger than random impulse moves. So I’m told anyway – I don’t have any proof of this and am in fact not a statistician. The point is though, financial markets are not random.
What this might mean though, is simply that our mind is very good at seeing patterns in data.
It would be an interesting experiment to trade a number of sessions of completely random data, to see if I could profit from it with the same level of performance as in the real markets. I imagine it would have to be done such that I did not know that these sessions were not ‘real’ so as to remove any influence that knowledge may have psychologically.
I’m not sure what the results would mean exactly. If I was profitable then I imagine it would mean that my results are solely a function of my psychology and money management; and have nothing to do at all with my strategy which has been developed based on my understanding of the nature of the markets.
Followup SMB blog posts:
The original article, linked to above, was followed by four further articles. Links for all six parts follow:
Part 1 – Random thoughts (or, rather, thoughts about randomness)
Part 2 – Another look at randomness
Part 3 – Randomness: the answer key
Part 4 – Volatility clustering: one way that markets are NOT random
Part 5 – Randomness revisited: random levels?
Part 6 – My list: some ideas for finding tradable edges
* I am unaware of the source of this xls file… if anyone knows it’s origin, please advise so that I can credit the source.