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01/03/05
Time and Deformation, by Dr. Brett Steenbarger

Driving along California's Route 1, connecting San Francisco and L.A., is conducive to uplifting speculation and, indeed, recently prompted me to reflect upon the market-related lessons I have learned in the past year. Perhaps the greatest lesson concerns the role of time as a market variable and, in particular, how deformations of time -- resulting from both market and personal activity -- impact trading behavior.

My lesson began when I observed that highly capable traders who specialized in one market consistently lost money when they tried their hand at different markets. Struck by the contrast of outcomes, I began to follow and simulation-trade two expressly different markets (let's call them A and B). My observation was that B displayed far greater non-stationarity than A. In other words, the time series of price changes during period 1 was far less likely to resemble the time series of price changes during adjacent period 2 for B than for A. Dramatic swings in volume and volatility -- as well as price direction -- in B made it quite different to trade than A.

The interesting phenomenon was that, while the markets traded differently, the traders' trading styles did not adjust for this. Some firms employ software that closely tracks trader behavior, providing metrics for such variables as number of trades (long and short), average holding periods of trades (long/short, winning/losing), time periods between trades, etc. Apparently, the metrics for the A traders did not significantly vary when they shifted to trading B; nor did they vary greatly from one period of the B trading day to another, despite the clear variations (non-stationarities).

My next observation was that B traders who were more successful were more apt to shift their trading styles and frequencies according to market conditions than those who were less successful. The less successful traders tended to have an invariant style that sometimes fit market conditions, but often did not.

To use Benoit Mandelbrot's phrase, market activity deforms time, creating a difference between operational time -- the time it typically takes a market to move a given distance -- and chronological time. Volume and volatility speed the market clock, but traders tend to function on chronological time. I suspect traders run afoul of ever-changing cycles precisely because of the inevitable chasms that separate chronological time from market time: chasms that are wider in some markets than others.

A related observation is that just as market activity and inactivity shift the operational clock, the trader's own activity and inactivity seem to alter his perception of time: the internal, subjective clock. When a trader is actively trading, perceived time is compressed; when a trader is out of the market, time passes far more slowly. Many emotional reactions of traders that affect trading, including impulsivity, anxiety and boredom, appear to spring from the subjective deformation of time that results from shifting periods of activity and inactivity.  I recall a trader I knew who would regularly scream at his screen, fuming about markets that would "stop trading". When I sat by the trader to observe his trading, I noticed that he would put on large positions when markets were active and then would feel time dragging as volume returned to its mean. Subjectively, he felt trapped in his trade despite the fact that the market was actually moving his way -- just not at his subjective pace.

It is little wonder that discretionary traders fare so poorly in the markets as a group. Between the time deformations imposed by changing market cycles and the time distortions imposed by our own subjective calibrations, it is difficult to truly "follow the market". We tend to treat time as a constant, in our charts and in our research. I suspect, however, that it is precisely the variability (and relativity) of time that imparts challenge to trading.