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The Speculator Effect

July 15, 2010

I would argue that when too many speculators are closely watching a market, classical technical indicators tend to fail more frequently. This tendency is something that I like to call “the speculator effect.” My theory is that this effect is more prominent when there is a consensus in sentiment surrounding fundamentals in the direction of observed indicator.  Similar to the Heisenberg principle in physics, the very act of observing a market closely can change its behavior. I would argue that major technical benchmarks are “gamed” and as a consequence a lot of false moves are triggered (on purpose) to enrich the smart money at expense of the dumb money. Since the market is larger than anyone can realistically manipulate for more than just a few days or weeks, many of the longer term indicators will be successful eventually. But the impact of  “the speculator effect”  is significant enough to take a large chunk of change out of your pocket if you are not wary.

One classic indicator that EVERYBODY watches is the 200-day moving average. This indicator is so important that CNBC and all the news providers and pundits report on it regularly. Even if you aren’t a technical analyst or a believer in technical analysis, if you are a fund manager, you probably watch the 200-day moving average. So here is an interesting experiment–lets trade the 200-day moving average on the S&P500 index using the SPY with two different trading methods: 1) TRADE ON CLOSE: the plain-vanilla trade long when today’s close is above the 200-day moving average, short when the close is below the 200-day moving average 2) TRADE NEXT DAY CLOSE: the same strategy but using the next day close to execute orders versus entering on the same day as the signal. What are the results since 2001?

Trade on Close:

CAGR: 3.75%

Max DD: 32%

Winning %: 18%

Average Trade: .62%

Trade Next Day Close:

CAGR: 5.74%

Max DD: 34%

Winning %: 42%

Average Trade: .88%

As you can see there is a remarkable difference of 2% per year in annual returns by delaying trades simply one day. Furthermore, the winning percentage goes up to 42%, and the average trade gets a boost of more than 20 basis points. The primary logical explanation for this is that the 200-day moving average crosses are gamed in advance and the smart money sells short or goes long prior to the cross and reverses direction to trigger stops following the day of the cross. When these stops are triggered they likely use the burst of liquidity to enter in the direction of the trend. The current market action of the “death cross” appears to be taking on the same pattern. The fear premium in today’s market is substantially higher given the bearishness of advisor and retail sentiment towards the economy—most of it completely justified. Unfortunately for the small trader, this fear premium represents a trading cost that they must pay to get out of the market when everybody else does. The speculator effect is something that traders have to pay attention to  in order to get the most out of their trading.

6 Comments leave one →
  1. July 15, 2010 2:11 am

    Great post! Thanks.

    • david varadi permalink*
      July 15, 2010 2:32 am

      hi blue, thanks a lot!

  2. Phil permalink
    July 15, 2010 3:41 am

    Very interesting indeed. I personally pay much more attention to the slope of moving averages – as you said, it’s harder to manipulate over several days…

  3. July 15, 2010 10:15 am

    simple yet informative!

  4. derek permalink
    July 18, 2010 9:44 pm

    nice work, David…my work in this area has been to build on Meb Faber’s strategy with 3 other factors to cut whipsaws from the “overwatched” effect. I hadn’t thought of testing a one day lag, but your example is quite instructive!

  5. MarketSci permalink
    July 22, 2010 8:16 am

    very kind of you david. glad to have played my very small part in encouraging you to join the blogosphere. here’s to many more years of collaboration! michael

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