Online Stockmarket Trading Update

I recently read an excellent book that has interesting application to the financial markets. The book is titled Ubiquity, Why Catastrophes Happen. This is not a book review; instead I will build on one of the key concepts in the book as it relates to trading any market.

Imagine dropping a single grain of sand onto a table, followed by another grain of sand and another and so on and so on. Initially a few grains of sand will form a small pile on the table and the addition of a single grain of sand will have very little impact on the pile. As the pile builds, the grains of sand will start to build up and the slope of the pile will become steeper. Now a single grain of sand falling on to the pile may trigger an avalanche. The new grain of sand may dislodge one grain of sand or a whole lot of grains of sand and the sand will continue to move until the pile becomes stable again. As the pile gets very steep it is possible that a single grain of sand falling onto the pile will result in a complete collapse of the pile.

There are a few things to note from this simple experiment:

* the triggering condition for any avalanche is always exactly the same, a single grain of sand being dropped onto the pile.
* the size of the avalanche can vary dramatically from a single grain of sand moving, to total collapse of the sand pile.
* the steeper the pile the more unstable the pile becomes.

Translating this experiment into a trading context we can get a few things from it.

Consider that each trading day in the market is like adding a grain of sand to the sand pile. Then any trading day could trigger a decline, with a down day being the primary trigger. You cannot tell the difference between one trigger and the next trigger as you cannot distinguish between two grains of sand. It is a human tendency to look for reasons why an event occurred, however the why is always exactly the same, another trading day.

A one-day drop could then rebound the next day or result in a multi-day decline or even the next bear market. Any down day could be a suitable trigger and the size of the subsequent move is unpredictable. The author did find a core relationship between the size of the event and the frequency that it occurs at. While one event was not predictable in size, the larger the collapse the less frequently it occurred and this was governed by a power law. As the number of grains of sand doubled, the avalanche was less likely to occur by a factor of 2.14. As the size of an earthquake doubles it is four times less likely to occur. Amazingly this power law holds for earthquakes, extinctions, storms and many other natural phenomena, with different numbers governing the relationship.

But the most important thing to get from this study is that when the market is set up for a fall it is far more likely to occur and any collapse is likely to be larger. The steeper the pile of sand the bigger the avalanches tend to be because of the inherent instability. Michael produced an excellent article recently on divergence and showed the current situation in a range of markets. The set up for instability exists. When you add to that the precarious financial situation of many governments, most noticeably Greece, high unemployment in the US, political unrest in the Middle East, the end of Quantitative Easing in the US and high commodity prices the sand pile certainly appears to be unstable.

The author notes that it is not possible to predict the size or timing of events, but it is possible to observe the steepness of the sand pile at any time. The death of one species could lead to mass extinctions, a small spark in the forest could lead to massive bush fire, or a wrong turn could start a world war. But for these devastating effects to occur the sand pile must be steep enough to be unstable.

Focus your study on the set up criteria, the events that determine whether the market is currently stable or reaching a critical state where the next down day could be the start of something big.

By Jeff Cartridge
Education Manager