Auction theory and market Fractals

Vis-à-vis Conversations with Nick

Nick Herbert is a long-time friend, who wrote Quantum Reality, and Elemental Mind, among other books and things.

NickOver the years we’ve had conversations about a wide variety of things, most notably his idea of “quantum tantra,” which is a branch of science he has worked to spawn, and to graft on to the physics tree.

Quantum Tantra is a field without strict boundaries.  But broadly speaking, the idea is a physics based approach to new forms of communication, telepathy, and experiences shared so deeply they change and expand our experience of “identity.”

Tantra itself I have defined elsewhere as transformative practice.  It is the art of using ordinary things and parts of life in novel ways, to cause events and experiences that transform us in evolutionary ways, mentally and physically.

I have tried to approach life tantrically whenever I see the opportunity.  Trading is one such opportunity.  It has certainly been transformative for me.

In recent years, since I’ve been trading, I occasionally have harassed Nick with this irritating (to him) topic.  He has an innate distrust of the financial world.  And yet, he has never shied away from the irritating grains that may produce pearls.  (Or maybe he just puts up with me because he’s friendly.)

His questions of me, challenges, and arguments, have been a catalyst for thinking things through in new ways.  Nick is a very smart person, who claims to know nothing about financial matters, trading, markets, etc.

And yet, he is not a tabula rasa.  He brings to the conversation a lot of biases, aversions and fears, that I believe are common in various forms for many people.

He feels is suspicious that financial markets are rigged so that the little guy cannot compete.  That in fact they are purposely crafted to pick pocket unwary mom and pops, greedy youngsters hoping to make a quick buck, etc.

So discussions with him at times endeavor to not only present an objective view of what markets are, and how people can compete in them, but also what types of scams might be real, and which ones are bogey men, fictitious scary things, which, rather than actually stealing innocents or their money, might actually serve more to keep ordinary people in poverty by scaring them away from participation.

There are several topics that I know need to be discussed early in the Trading Primer, in order to make trading approachable for ordinary people, starting more or less from scratch.  Auction Theory, Sentiment, Fractals, the products of markets and their purposes (stocks, bonds, derivatives), market history (why the market exists, and where it came from), and so on.

Some of these topics have come up in a conversational way with Nick.  I’m presenting them pretty raw here.  They might need to be cooked in to a more finished format for final consumption.

Here are a couple of topics we’ve recently discussed.  This is just round 1.

Auction Theory

Nick wrote:

Kelly —

From what little I know of trading, there seem to be varying schemes for extracting

money from what seem to be quasi-random motions of prices. It reminds me of the

classic Maxwell Demon who tries to violate the 2nd Law of thermodynamics by opening

a door between two chambers both at the same temperature. He opens the door when a

fast gas molecule is going left. Pretty soon lots of fast molecules are in the left chamber

so it becomes hotter and can be hooked to a heat engine which only works on

TEMPERATURE DIFFERENCES. So the demon takes a situation where no work

can be extracted and changes it into a situation where work can be done. It’s called

a perpetual motion machine of the Second Kind.
Likewise a person second guessing the stock market is trying to extract net income by buying

low and selling high using some sort of scheme for predicting future moves of the market.

—————————————————————-

Kelly Responded:

Nick,

Your first sentence is correct.  Trading is based on schemes (plans) for extracting money
from the markets, which are quasi-random changes of prices.

Quasi is the operative word.  Exactly the right word.  Quasi=”seemingly; apparently but not really.”

Auction theory

One thing many traders find helpful is “auction theory.”

There are different ways to view the market, and one is as an auction.

Everyone knows what an auction is, a market of people bidding up the price for whatever,
corn, beans, gold, a car, a cow, Apple stock, whatever.  Each time the auction starts, the auctioneer throws out a price.

Who will give me $100 for a share of Apple?  Who will give me $41 for a barrel of oil, whatever.

If there are no takers, he goes lower, until he finds buyers.  That is what is happening when price goes down.

Then buyers are found, and like in an auction, they bid the price up.

Auctions can be seen as happening on various time frames.  There is the auction of the day, or several throughout the day.  And then day after day, there is another auction for the same type of item, for corn, or old Ferraris, or whatever.

So, if you can see that prices are going up, from one auction to the next, throughout the day, you could buy an old Ferrari in one auction, and turn around and sell it higher an hour later.

If you could see that day after day, Ferraris keep auctioning higher, you could buy one on one day, and sell it higher the next day, or a week or two later.

It’s also the same as flipping houses in an appreciating housing market.

Prices change in an auction for two reasons:

1. Sentiment (people keep wanting that item more and more, for whatever
reason….they are driven by the enthusiasm of the auction itself.  They want it
more and more, BECAUSE everyone else wants it more and more.)

2. Fundamentals (corn keeps getting higher because there is a growing demand
for corn relative to the supply.  Supply is shrinking, or demand is growing, for
actual reasons…not people’s feelings.)

Auctions seeking buyers:

Other ideas about auctions that has been helpful to me:

The purpose of markets is to seek buyers.  Markets always want to go up.

When you think of markets as an auction, and price falls, you see this as the auctioneer offering the item at a series of lower prices.  The auction is seeking buyers.

The sellers in a market are the auctioneer.  If the seller is selling “at market,” then they are the auctioneer offering the item at any price.

If the seller has set a limit order, that is like setting a reserve in an auction.

One reason ideas like “auction theory” can help: they can help traders to stay objective, not get emotionally freaked out, and make wrong choices based on those emotions.


Rules of Sentiment

The market always reacts to sentiment, when sentiment hits an extreme.

Markets top when most people are euphoric about a product, they think it will always
go up.  That’s when it tops and starts going down.  And vice versa at the bottom.  When sentiment is widespread despair, markets bottom, and find buyers.

Why?  Because when EVERYONE is euphoric, it means everyone that can buy has bought.  There is no one left to buy.  This condition is called “overbought.”  So at that point, even a small amount of sellers can turn the market down, seeking buyers.  There just are no more buyers.


Maxwell’s Demon and Efficient Markets

You made the comparison of trading to the story about Maxwell’s Demon, and how that has been used to talk about the 2nd law of thermodynamics (and the problem with free energy.)

The assumed analogy I see is that market dynamics are like thermodynamics.  In college econ 101 classes, students are often taught that markets are “Efficient.”

Efficient market theory says, the market is so smart that it constantly, instantaneously prices in all relevant data, so that all products in every moment are exactly, accurately priced.  And therefore, there is no way for a trader to make a prediction of what price will do next with any more than a 50/50 probability of being right.

Students are led to believe that “Efficient markets” are like the laws of thermodynamics.  Factual laws of nature.

The idea of efficient markets suggests that trading profitably is impossible, because there are no market inefficiencies for traders to exploit.  If they win, or earn, in this theory, it’s only luck…a temporary situation; and they will at best end up break even.

To successful traders who have earned a living, or even a fortune, through trading, over years or decades, this is laughable.  Although it may be comforting to the supposed majority, who fail and lose.

As an aside, this Maxwell comment also reminds me of Ken Keysy’s Demon Box…the title referred to the the Maxwell story.  Someone in Keysy’s book, maybe a crazy person, I forgot who, said, the Maxwell problem is only a problem in a closed system.

I didn’t start this comment to talk about the physics side of this.  I have no idea about
that.  I only have a strong belief that the “efficient markets” idea is incorrect.

Quantum Markets dynamics

What I did want to talk about is Newtonian physics vs Quantum physics, vis a vis markets
and trading.

I want to change the analogy.  I think Newtonian physics is analogous to the efficient market theory.

In fact, btw, even Tom Sosnoff, a 30 year + trading veteran, who invented Think or Swim,
one awesome piece of software I use, which Ameritrade bought from him for $600m…espouses something like the efficient market theory.

Sosnoff subsequently proceeded to invent tastytrade, and dough.

These are also great sites, with a ton of free and well-presented educational materials.

In short, he recommends trading options, rather than stocks or futures, since options can be traded non-directionally.

Specifically, if you SELL options, you are like the house, in a gambling casino.  Since 80% of
all options expire worthless, statistically, you should earn money as a seller.

However, as opposed to buying stock, or options, where your loss is limited, but your gain is potentially unlimited, when you sell options, it’s the opposite.  Your gain is capped at the sale price, but your loss is potentially unlimited.

So that, if you just sold options at random, with NO sense of what direction anything might
move, or how far, or on what time frame, you might earn money for a long time, bit by bit,
then one day, lose it all, all of a sudden.

So EVERYONE that trades ANYTHING, “should” have SOME sense of how to predict direction, pace, wave lengths, etc.  Traders need to get used to thinking PROBABALISTICALLY.

Even Sosnoff MUST have some sense of direction, unless he’s a trading loser, and just makes
his money making (great) trading software.  (“You only have to get rich once.”)  And, btw, Sosnoff does seem like a terrible predictor.  He’s a perma-bear.  He’s been saying the market
is going to go down, for years.

(Just like Soros.  Soros must be down billions since his big short last spring…2016.  Soros is always saying how Europe and China and the US stock market is about to crash.)

So, back to finishing my physics analogies.

While I think the idea of “efficient markets” is like Newtonian physics, I think in reality
markets are like Quantum physics.

This may not be a precise analogy.  But I’m thinking about the observer effect.

In the same way that Quantum physics showed us that the observer affects the reality s/he observes (it’s impossible to be an “objective” observer), similarly, markets are not an objective clockwork mechanism.

The participants (who, in efficient market theory, supposedly exactly, perfectly, instantaneously
price all products perfectly, in every instant,) are actually people, with their messy emotions, their hopes and fears, wrong ideas and cognitive dissonance, manual errors and so on.

This is not to mention that a single player with a large account can LITERALLY personally move a market, in whatever way his whim suits him, for whatever reason.

I recounted a famous story about that, at the very bottom of this blog post:

Crude, in the zone 2

But even if you are not a giant, it sentiment that makes markets inefficient, and creates asymmetrical risk/reward situations, constantly, on every time frame, that traders can exploit.


Algo arbitration

People may say that, even though efficient markets didn’t work before, they will soon, or they
will someday, due to algorithmic trading.  And that may be true.  I don’t know.  But it’s not
true yet.

So far, algorithmic trading is still a version of people trading.  People make their trade plans
and ideas, and code them as algorithms, that trade.  So for now, it’s still people.

And markets constantly change.  Algos as they currently are, are disadvantaged compared to
people in this way, since people, if they are mentally flexible enough, can constantly adapt as
they recognize changing market characteristics.  Algos have to be recoded.

My old friend Dave Knight, (formerly Dead Head Disco Dave) who is working at Google now, just started tinkering with trying to get machine learning to sort through market data, and make a plan for him.  But this is early days for that.


More physics analogies

Nick wrote:

Kelly —

Treating the market simply as physics:

  1. In a rising market there are more winners than losers (actually net money win, not necessarily net people win)
  1. In a falling market there are more losers than winners.
  1. There exists the phenomenon called “bubble” where a commodity is over-valued but the price is still rising. The bubble attracts lots of investors and the game is to become the last guy to sell before the bubble bursts.
  1. In any market, there is only so much money in the pool. And large cash, sophisticated investors have the advantage over small traders. Small traders however contribute to the pool.
  1. Large cash, sophisticated investors are strongly motivated to increase the size of the money pool either by increasing the number of small investors or by dragging an untapped money pool into the investment sector.
  1. One large untapped money pool is social security (which by law is invested in treasury bills hence “secure”).

That’s my six cents, for what it’s worth.

Nick


Kelly responded:

Nick,

I agree with a lot of what you say here.  But I think some of it happens for other reasons than what you are thinking.  And some of it has nuances that are important to recognize

I don’t want to overdo the physics metaphors.  Because now I’ll mix them.  Now I’ll use Newtonian vs Quantum physics to represent a different set of relationships.

In this case, I think a lot of what you say is like Newtonian physics.  It is how reality seems to work, appears to work, and in a lot of ways does work.  But there is a hidden weirdness underneath that, which is factual, and means things are fundamentally, and actually, not what they seem.

In physics, the weird truth is quantum reality.  In economics, its central banking.

Intuitively, money seems to be an actual thing, as in physics, matter seems to be actual stuff, at some level.  (Surely at some level, like atoms, there is some fundamental particle?  Surely at some level, money is backed by some “thing.”)

In the reality of central banking, and fiat currency, money is created through lending.  Money is debt.  It IS an actual thing after it comes into existence.  You can use it to buy things, put it in a bank, and so on.

In quantum physics, “reality,” matter is created through observation.  Until it is observed, it “might” be there.  It’s a wave, a possibility.  Once you look at it, it becomes a particle, a thing.  Any amount of money “might” be there.  There is no limit.  In fiat currency “reality,” money becomes a thing when it is lent.

How does this change how money seemingly works?


Nick:

Treating the market simply as physics:

  1. In a rising market there are more winners than losers (actually net money win, not necessarily net people win)
  2. In a falling market there are more losers than winners.

Kelly:

The question is what you mean by a “market.”  There are so many ways to be invested.  The world of total “currency” is literally currents, flowing through a vast ocean of capital…even arguably, the whole atmosphere, including currents of air, wind, gravity, and so on, to complete the metaphor.

Every day, and on bigger time scales, money is flowing in to and out of various “markets.”  There are bond markets (government and corporate) which are 3x the size of the world’s stock markets.  Money flows between bonds and stocks and commodities daily.

So within any sphere, there are constantly winners and losers.

But the only way the total pool of money is ever shrunk is when loans default.  And the only way the total pool of money is ever expanded is when loans are issued.


Nick:

  1. There exists the phenomenon called “bubble” where a commodity is over-valued but the price is still rising. The bubble attracts lots of investors and the game is to become the last guy to sell before the bubble bursts.

Kelly:

This is true in many ways.  But an important nuance to be aware about is how central banks and banking practices in general can inflate and deflate bubbles, by increasing and decreasing the money pool, with their practices of manipulating interest rates,and printing money (QE).


Nick:

  1. In any market, there is only so much money in the pool. And large cash, sophisticated investors have the advantage over small traders. Small traders however contribute to the pool.
  2. Large cash, sophisticated investors are strongly motivated to increase the size of the money pool either by increasing the  number of small investors or by dragging an untapped money pool into the investment sector.

Kelly:

This is one of the main points I was speaking to above.  It is true that sophisticated “high net worth” individuals do tend to benefit more, in any market conditions, than the small fries.  But it’s not just because they are luring the small fries in to the market to steal their money, and aggregate it themselves.

It’s because they understand how money works, how the game works, and they are more able to take advantage of that.  And they have other advantages, even if they don’t understand it.  There are more reasons than one that the rich get richer.

I talked about this in my macro blog, about the relationships between the dollar value, stocks, bonds, and commodities.

Market vehicle correlations, 20 year charts

Look at the charts, and you can SEE what happened, in 2008.  When the housing boom crashed, the way lots of small fries lost, was because their loans defaulted.  Then, the government, in cahoots with the central bank, response was, print money on a HUGE historically unprecedented scale.

So small fries lost $4.5 TRILLION.  That money disappeared from existence.  $4.5 trillion of new money was created to replace the money they lost.  And who got that money?  High net worth, financially sophisticated entities.  THAT is how the money transfer was accomplished.

Remember after 2008, lending practices were “tightened?”  And yet, that money the central banks printed could not be made “real,” unless it was lended in to existence.  It was still a quantum wave of possibility, sitting on bank ledgers as potential capital.

The ostensible reason lending practices were tightened?  So that we wouldn’t get another housing boom type situation.  The actual consequences of the practice?  Small fries could not borrow the money, because their “credit” was not good enough.

Who could borrow the money?  The US government borrowed a goodly chunk of it in to existence.  Who got the rest?  High net worth individuals who still had good “credit.”

What did they do with it?  Look at the charts.  Look at the SP500, bonds, gold.  Buy buy buy, the entire time the money printing was happening.

THAT is what happened.


Nick:

  1. One large untapped money pool is social security (which by law is invested in treasury bills hence “secure”).

Kelly:

I have addressed this years ago in our email conversations.  There is no “reserve” of money in T Bills.  That money has all been long since “spent.”  Circulated in to the economy.  The value of bonds is purely based on future potential earning.  US T Bills are valued solely based on the concept that the US economy will “grow” forever.

It is the “mission” of central banks to maintain a steady rate of “inflation,” so that money, and debt, constantly devalues.  If they ever fail in this mission, and we get significant deflation, it will be catastrophic.  I’ve comment on that too here and there in blog entries.


Fractals and randomness

On 8/8/2016 4:07 PM, nick herbert wrote:
Thanks for the story, Kelly.
Although I was not able to figure out your thinking
It was indeed amusing to follow your story.

Trying to second guess randomness is not easy.

Reminds me of a story told me by a psychic investigator,
Hal Puthoff who was studying distant viewing. He was testing
a person 1000 miles away who believed he/she could bilocate
and look thru Hal’s lab window in Menlo Park. OK, says Hal, each
day I will put a big tomato in my window (or not) and keep it there
all day. Your job next week is to write down which  5 days MTWTF
are tomato days and which are not. Then I will compare your
results with reality.

So Hal throws a coin 5 times to determine the tomato days. He gets
5 heads in a row. Hence all five days were tomato days.

Needless to say the distant viewer didn’t come close: His/her guesses
were more “random” than reality.

Some days reality is like that.

Nick


Kelly:

Haha…yeah.

But I repeat, I aver, markets are not random!

But there are lots of ways to trade them….all kinds of time frames, products, etc.

I saw a video once about Wall St people.  The interviewer talked to a hedge fund manager, who was looking to hire young talent.

He said, “We want people with new ideas, like they trade based on elephant migratory patterns in Africa.”

The interviewer laughed.

The hedge fund manager said, “No seriously, we have a guy….that’s his system. He’s really good.”

The elephant story sounds funny, but I’m sure the guy was serious.

They probably really did have a trader who based his ideas on elephant migratory patterns,
and really did do well.

Why?  Because elephant migratory patterns are not random.  They are part of nature.
And markets are made of people.  And people are part of nature.  And the things they do are not random.

Why does price repeatedly stop at Fibonacci levels?

I have a friend who trades big size, and does well, and uses these a lot.  He introduced them
to me.

When I first saw the phenomena, I asked, “do you think this is because it’s built it to nature,
or because traders have this idea, and create the phenomena?”

“Well, obviously the latter,” he said.  I never knew when he was pulling my leg.

I looked up when people first thought of using fibs on prices.  Then I found old charts, from beforethose days, and calculated the levels.  Price always did that.


another comment on quasi randomness in markets:

Markets operate on fractal principles, like organic things in nature.

Watch charts all day, or study them long enough, and you’ll see it.

In the same way that a river flows downhill, and will take a straighter
route on steeper parts, and will seem to meander randomly on flatter
parts….but when you fly over in a plane, you can see the fractal pattern…

or a tree, always growing up toward the sun….there is the main thrust,
then the quasi random outgrowths, which tend to form a type of symmetry,
but within that symmetry appears chaos, randomness….but often if you zoom
in, there is another level of symmetry….

And if an earthquake drops a boulder in the river’s path, or the Fed
announces rate hike, or whatever….the flow suddenly reacts, things
get wild, and then it finds a way to subsume the whole thing in
fractal symmetry…

and likewise, markets move like that, the main thrust, which is straighter,
and then the seeming noise in flatter, slower areas, where it gets messy,
which if you zoom in on it mirrors the thrust, and noise, and zoom, until
you get to a level where you can’t decipher, or trade, the noise, any more.

Usually, when you zoom out from something that seems random, you
find out how it was sub-sumed in a larger fractal….it can be fascinating,
beautiful.  It’s like watching something grow in nature, which is usually
too slow to see.

You can see it historically on charts, but when you try to trade it, you live it in real time


deeper into the quasi-random fractal metaphor:

In the same way the nature of a tree “knows” it wants to reach towards the sun,
and just grows, and goes….the nature of a stock like Apple, when it releases the
iPod “knows” it wants to go up….it does not know how far it can go, or how it will
get there, but it just goes, and grows….

Just as the nature of a river “knows” it has to go downhill, reach for the sea….
the natures of the oil market “knows” when the Saudis said they would over produce…
it has to go down…it doesn’t know how far, or fast, it just breaks, and falls…

(whatever the reason, it may seem like the Saudi thing, and turn out to be
really secretly driven by the fed’s actions which inflate the dollar….doesn’t
matter….you can see the knowledge, the instinct, in the action)

and markets rise and fall according to the same principles as trees grow
and rivers flow…in bursts and fits…gathering themselves and reaching,
falling, further…until the tide turns

and Apple someday fucks up, or demand picks up, or the dollar falls, and
oil must find it’s way back up, over a hill….it pools, and looks for a way to
rise….it’s course follows the same furrows through which it fell…

the life force starts contracting back in to the Apple tree…as it goes down,
it fills in the same areas where it’s branches grew before, according to it’s
nature….but it never goes in the same exact place twice…it fills in the “gaps…”

markets are natural, don’t fight it, go with the flow Nick, (read, Kelly)…

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