Statistical Anomalies In Emini Futures Trading
October 15, 2012 at 10:02 PM (QQQ)(DIA)(SPY)(GLD)(FB)
A little Emini History was made today. The sky isn't falling, the S&P is still comprised of 500 stocks and we're definitely moving higher from here unless we start to break down.
What Is A Statistical Anomaly?
There's a lot of big words on Wall Street. Even the retail trader on Main Street will be required to expand his or her vocabulary to include words like:
- Relative Strength Index
- Backwardation
- Calendar Spread
- Call Premium
- Dark Cloud Cover
- Dark Pool Liquidity
- Dealing Desk
- Margin Call
- Fair Value
- Fat Finger
- Paper Trading
- Sarbanes Oxley
- Derivatives
- MACD
- Maintenance Margin
- Parabolic Move
- Zig-Zag Indicator
- Market Breadth
- Advance-Decline
The actual list is far more extensive but the good news is you will learn them over time as needed. Some you will never actually use and will only learn their meaning in passing. You will however start to sound quite clever at cocktail parties and bar mitzvahs. Be careful how you throw those words around because once people become convinced you actually know what you're talking about, they will start throwing money at you and insist that you trade it for them. Don't do it!
As tempting as it will be, as much as it will inflate your ego, there is nothing as dangerous as an inexperienced trader with his hands on other people's money. You already have more than enough pressure trying to manage your own account. There may come a day when you mature into a trader who is both confident enough and competent enough to manage funds for others. Unless you're a child prodigy don't even think about it for the first 2-3 years. Don't worry, you won't lose the opportunity. In fact, the more elusive you appear the greater their desire will be to put you to work.
When the time is right you will know. For some traders, it will never be a good fit. I will touch more on this subject in coming days. Let's get back to our topic at hand.
A statistical anomaly occurs when something falls out of normal range for one group, but not as a result of being in that group.
sta·tis·ti·cal/stəˈtistikəl/
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statistic
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a·nom·a·ly/əˈnäməlē/
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abnormality - irregularity - aberration - abnormity
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Warren Buffett: Investment Genius or Statistical Anomaly?
Warren Buffett has been Chairman and CEO of Berkshire Hathaway, a general investment
company, since 1965. Before that he headed various private investment partnerships. Over a period of 47 years, under Buffett’s leadership, these companies have outperformed broad market indices by an average of 11.16% per year. In 42 of the 47 years he has outperformed the market. Despite this record, rarely do any standard investment, finance or economics texts mention Warren Buffett. In this paper we look at possible reasons for this and examine the question posed in the title, namely whether or not Buffett is simply a statistical anomaly.
The Orangutan Coin Tossing Competition
In 1984 Columbia Business School hosted a celebration of the fiftieth anniversary of Graham and Dodd’s book Security Analysis. The two principal speakers were Rochester’s Michael Jensen, an academic who had come out strongly in favour of the Efficient Market Hypothesis and Warren Buffett. Jensen stated that it was hard to tell if any of the followers of Graham and Dodd were really superior investors. He argued:
If I survey a field of untalented analysts all of whom are doing nothing but flipping coins, I expect to see some who have tossed two heads in a row and even some who have tossed ten heads in a row.
This was a perfect entry for Buffett who envisaged a national coin-tossing contest. Each day, everyone in the United Sates flipped a coin with only those who continually flipped heads staying in the contest. After twenty days only around 215 flippers would remain.
Buffett continued (Buffett, 1984):
But then some business school professor will probably be rude enough to bring up the fact that if 225 million orangutans had engaged in a similar exercise, the results would be much the same—215 egotistical orangutans with 20 straight winning flips.
Buffett then argued that there were important differences. What if, for example, all the orangutans came from the same zoo? When you replace head-flippers with “superinvestors”, he argued that this is precisely what happened. Buffett declared that there was an unusually high concentration of successful coin flippers, that is, “superinvestors”, in the investment world that “came from a very small intellectual village that could be called Graham-and-Doddsville”. Buffett put forward the view that a “concentration of winners that cannot simply be explained by chance can be traced to this particular intellectual village.”
The statistical anomaly we saw on Friday could have any number of explanations. One of our Partners is currently working on a an in-depth analysis of the Weekly Trading Zones and their relationship to the concept of standard deviations. We fully support the research and do hope to see a published paper in the near future. Any Partners who may have compiled similar data already, please let us know and we will make sure you both have an opportunity to share notes and ideas. This is Community at work.
On Friday one of the highest probability setups that we can present from a larger time frame perspective appeared. The odds said the market would close on Friday at or above 1428. It didn't. The market closed the week at 1421.75. The purpose of the research paper is to help identify why this occurred. We already know that 8 out of 10 times the market will close the week inside the most extreme Zones. Why it doesn't 20% of the time is almost as big a mystery as why it does the other 80%. This field of study may very well solve both mysteries.
This phenomena is not something we sat out to achieve. After 6 months or 24 weeks of publishing the Zones for our Partners, the fact simply leapt off the page. It was undeniably obvious and without rational reason. At that point I thought I had spotted a statistical anomaly. Turns out, what I had spotted was actually the norm based on the mathematical formula I developed for creating the Zones. After 18 months of consistent behavior I became convinced otherwise.
The bottom line is that last weeks performance, Friday in particular, was an outlier.
In statistics, an outlier[1] is an observation that is numerically distant from the rest of the data. Grubbs[2] defined an outlier as:
An outlying observation, or outlier, is one that appears to deviate markedly from other members of the sample in which it occurs.
So in the world of trading you will always encounter these "outliers" and of course the occasional "out-right liars" but that's the truth about trading. We are quick to admit there are many facts in the markets for which we have no real explanation. The self-fulfilling prophecy of trend lines and price channels are one such example. There is a strange yet strikingly beautiful geometry that exists within price action itself. Not only can't we explain it, we can't stop it, nor can can we worry it away. It simply "has been" since the markets began and "will be" until the end of time.
What we do understand is that through the power of observation we can still participate in profitable trading opportunities based on statistical reliability even though our reasoning may be flawed and in many cases non-existent. Sometimes, you just gotta' have faith...
As opportunities unfold we will keep you posted.
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