Reflexivity And Trend Following

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Victor Chan Wai writes: George Soros is unarguably the greatest fund manager ever lived who, upon the request to disclose his secret, attributed his success to a market behavior theory he developed himself, which is now famously known as the theory of reflexivity. The basic assumptions of the theory as well as its implications to the formulation of a successful trading strategy will be discussed in this article.

Reflexivity vs. Traditional Theory.
While market participants are assumed to be rational observers in traditional economics, Soros proposed that participants are irrational, and they interact with the market in a way that firstly, on a cognitive level, the participants study the news and form a bias of the future (e.g. the stock will go up), and then, on a participation level, they collectively act according their bias (i.e. buying the stock) and change the market reality (i.e. the stock price jumped), which in turn provides new facts to reinforce the bias (i.e. the stock will go even higher) until the reinforcement fades or an opposite bias is formed.

The theory of reflexivity is applicable more than just in the stock market. One historical example was the US dollar under President Carter and President Reagan, which, in the former case with Carter, depreciated and sparked inflation under a weak-dollar policy, and when the inflation encouraged the dollar to be shorted, the dollar dropped further and raised inflation in a vicious cycle, in steep contrast to the latter case with Reagan who adopted a strong dollar, hammered the inflation, and created a benign cycle for the dollar.

The Three “U’s” of the Market.

Three characteristics of the market could be concluded from the theory of reflexivity, which can be summarized as 3 “U’s”. The first “U” is “Unstable”. Traditional economics assumes that any change in price would be corrected towards an equilibrium, e.g. when the price increases, investors would sell it back to a lower level, but this is not usually true in a bull market in which instead, as suggested by the theory of reflexivity, a rise in stock price increases the bullishness of the investors, and in return their bullishness increases the stock price, so that the price has a tendency to move away from the supposed equilibrium and produces a trend.

The second “U” is “Unfathomable”. This is not to say fundamental analysis to be completely useless, but according to Soros, it has two shortcomings. Firstly, information is imperfect and very often the most important information, without which any decision is bound to be inaccurate, is already digested in the price before it becomes apparent; and secondly, fundamental analysis ignored the interaction between price and fundamentals, e.g. an increase in credit rating of a company may increase the stock price, but an increase in the stock price may also indirectly improve the credit rating, and the latter part of the interaction is usually ignored in traditional fundamental analysis.

The final “U” is “Uncertain”. You can never predict what’s next in the market. Soros once had a habit of rationalizing his decisions to his son, and later his son infamously criticized him, “My father will sit down and give you theories to explain why he does this or that. But I remember seeing it as a kid and thinking Jesus Christ, at least half of this is bullshit. I mean, you know the reason he changes his position on the market or whatever is because his back starts killing him. It has nothing to do with reason. He literally goes into a spasm, and it’s this early warning sign.” Soros was correct to feel uncomfortable about his mistakes in the market, but rationalizing it to someone else would only make it a joke itself.

The Four Principles of Trading.

With the three characteristics of the market elaborated above, we arrive at the following principles of trading:

1. The price has the final say. You may have an opinion on the market, but it is dangerous to marry it to your positions, as famous trader Richard Dennis explained, “You don't get any profits from fundamental analysis; you get profit from buying and selling. So why stick with the appearance when you can go right to the reality of price and analyze it better?”

2. Follow instead of forecast. Legendary trader Paul Tudor Jones once declared that he would never hire fundamental traders who frequently tried to outwit the market and got burned, because by the time the fundamentals become clear, the trend is over. You can never know if the next trade wins or not, so simply follow your rules and see.

3. Preserve your capital. Since the market is impossible to forecast, all great traders agree that you must limit your losses before it gets out of hand, since they have seen a lot of intelligent traders got bruised in a market crash simply because they held on to the losers or even averaged down on the way as the price became “fundamentally” attractive.

4. Let your winners ride. The other side of the coin is not to cut the profit too soon before it can grow large. Jesse Livermore explained, “I've known many men who… began buying or selling stocks when prices were at the very level which should show the greatest profit. And … they made no real money out of it.” Why? They sold too soon.
   

On Trend Following.

One of the best strategies which work according to these principles, and are tested to be profitable empirically, is trend following, which in fact is an important element of the trading strategy of Soros. According to trader Stig Ostgaard, there are three elements in a trend following strategy, which are, firstly, to enter positions based on the perceived trend; secondly, to hold positions going in favor of the trend; and finally, to exit positions going against that trend. A possible fourth element is to perform the above with systematic rules backed up with computer analysis, but this is not absolutely required, since it is certainly possible to follow a trend without computers, for otherwise how was it possible for “ancient” traders like Jesse Livermore to make a killing?

As a matter of fact, it is exactly those traders before the digital age who serve as a proof of the simplicity of trend following. As a famous example, Nicolas Darvas was a professional dancer in the mid 90s who made $2,000,000 in stocks within the short 1957-58 bull market, despite of the handicap that he was on a world ballroom dancing tour and always received his subscription of the Barron’s one week late in an age without the internet or any electronic trading platform! His secret was so uncomplicated that his approach was actually nothing more than a simple breakout system applied in a number of stocks recommended by the Barron’s, with which he exited the losers upon the trigger of a stop, and held on to the winners until the opposite breakout occurred. If he could do it, so can you.

Conclusion.

The methodology of developing of a trading system is beyond the scope of this article, but by now it should be clear to you that you do not have to be very smart or knowledgeble to beat the market, you simply have to be humble and follow the mass. Trend following is one of the easiest ways to take advantage of the unstable behavior of the market because it simply requires you to follow the market instead making complicated predictions. Surely it is not the only way to skin the cat, but it is a very good way.

http://wisdomisprofit.blogspot.com

Victor Chan Wai-To is a currency trader based in Hong Kong.

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