We Don't Know as Much as We Think We Do

Traders don’t know much either. I’m not talking about general ignorance, but specifically that the history of markets is nowhere near as big as we often assume. For example, equity options have only been traded in liquid, transparent markets sine the CBOE opened in 1973. S&P 500 futures and options have only been traded since 1982. The VIX didn’t exist until 1990 and wasn’t tradable until 2004. And the average lifetime of a S&P 500 company is only about 20 years.

This might seem like a decent length of history that we can study and look for patterns. But I doubt that it is. I think that while there appear to be many thousands of data points, there might only be dozens. Options and volatility wiggle around a lot but their long-term values are related to macro variables such as inflation, monetary policy, commodity prices, interest rates and earnings. And these change on the order of months and years. Even worse, they are all co-dependent.

I think this makes quantitative analysis of historical data much less useful than is commonly thought.

But there is something we can rely on: human nature.

Humans have been essentially psychologically unchanged for 300,000 years when Homo Sapiens (us) first appeared. This means that any effect that can conclusively be attributed to psychology will effectively have 300,000 years of evidence behind it. This seems to be potentially a much better situation.

The problem with psychological explanations (for anything) is that they are incredibly easy to postulate. As the baseball writer Bill James said, ‘‘Twentieth-century man uses psychology exactly like his ancestors used witchcraft; anything you don’t understand, it’s psychology.’’ The finance media is always using this kind of pop psychology to justify what happened that day. “Traders are exuberant” when the market goes up a lot; “Traders are cautiously optimistic” when it goes up a little etc. I think psychology can be incredibly helpful , but we have to be very careful in applying it. Ideally, we want several psychological biases pointing to one tradeable anomaly and we want them to have been tested on a very similar situation to the one we intend to trade.

This is the focus of my current research and I’ll be giving examples over the next few weeks, beginning with behavioral explanations of well known volatility features and hopefully leading to some new trading ideas.