Connections The study of interrelations between markets, and between trading and other fields, may lead to fruitful inquiries. Our efforts along these lines are memorialized in "Education of a Speculator" (Niederhoffer, 1997) and "Practical Speculation" (Niederhoffer and Kenner, 2003). We continue to explore such interrelations in our own work and with members of the Old Speculators' Association, and are pleased to present a selection here. Home

9/05/2005
Evaporation & Markets, by Victor Niederhoffer

With all the news about excessive water, I thought it would be good to study up on evaporation, the process by which water is turned into gas. Evaporation is the primary force in the water cycle process by which water moves from the liquid state to the atmosphere and then back to the ground. What I learned about evaporation is quite different from what I read in school. It depends on pressure and entropy, for example, as well as the common factors I learned about in school such as wind, humidity, energy and temperature. A good article on this is "Why do things sometimes melt and sometimes sublimate?"

To simplify, Evaporation is going on at all times. Its rate depends on the distribution of molecules and how many are close to speeds necessary to turn them into a gas. (I would be pleased with a more precise market-related simplification.)

I hypothesize that evaporation in the stock market comes when a stock or other market is near a new high or new low and it receives energy from the fixed momentum boys to raise it to new highs or lows. The process provides a net cooling of the stock market, which I analogize to a net reduction in volatility. And when the markets or stocks setting new highs or lows return to the non-extreme parts of their distribution there is an increase in the velocity and temperature of the market.

I hypothesize also that other things that provide evaporation for the market would be sources of heat from political , monetary or weather events. The rate of these process will depend on the volume of trade during the day according to the same principles in the sublimation article.

Someone's going to tell me that I am an ignoramus and clown for trying to draw analogies from this simplification, and that markets are different, and that it's already been done in the area of econophysics or some such, and I tip my hat to them and join them in their critique.

Dr. Kim Zussman comments:

One could also look at the Boltzmann distribution, which describes the kinetic energies of (say) molecules in a beaker of boiling water. None of the molecules are perfectly stationary (absolute zero), and most move at speeds consistent with the overall temperature. However some have energies many times the average temperature, and are much more likely to escape the hydrogen-bonding and gravity holding water in the beaker.

Mr. Ckin adds:

Maxwell-Boltzmann had some particular constraints and assumptions in order to make the curve continuous. Among them, the sample only applied to an ideal gas (not a "sticky" gas in which electromagnetic induction or electronegativity would cause to molecules to interact), all molecules would be in the ground state, and there would be no collisions which would cause an excited state of any molecules. I think that it also assumes cold gases, which would not lose radiation into space.

I remember doing fairly well in statistical mechanics in college, but when I went back to look at my old notebooks, I see handwriting that looks like mine, but the math (differential equations, triple integrals) looks like a foreign language. Nevertheless, statistical mechanics probably has lots of relevant tidbits for financial markets, but when one starts to consider differential equations relating to dynamic systems, keep in mind that there are an infinite number of solutions.

Here's an issue that I have been pondering relating to dynamic systems and moving bodies as they relate to financial markets: Is volatility a mean-reverting quantity? Any sort of volatility measure will do, VIX, VXN, historic, implied, average daily trading ranges, etc. Grant's Interest Rate Observer touched upon this question a few months ago, but with limited reference to any analytical work. Knowledge of the answer would have a meaningful impact on pricing of securities with embedded options such as convertibles and MBS.

9/13/2005
Evaporation and Energy and Markets, by Henry Gifford

My attention is perked up for an opportunity whenever the general understanding of a field seems to differ from what I understand is reality. It is widely understood that there are 3 ways heat is transferred from one thing to another: conduction, convection, and radiation.

Radiation is the way the sun heats the earth without air in between, conduction is the heat transfer between things that touch each other, and convection is a current of fluid (gas or liquid) that is moved by a difference in temperature/density.

I think convection is a transfer of mass, not heat, which is where I diverge from the mainstream. I also think "change of phase", such as the energy involved in evaporation, is another form of heat transfer. Nobody seems to deny this very loudly, but they still stick with the original three, and ignore this one, much to their peril when it comes to making energy and water related decisions.

The "latent" energy involved with changing water (or other substances) from solid to liquid or gas and back is substantial. For example, the energy it takes to change water from liquid to gas is about 7 times the energy it takes to heat water from room temperature to boiling temperature. Overlooking this is perilous, but is done all the time.

Change of phase is how dogs that don't sweat cool themselves, how people cool themselves by evaporation (sweating, breathing), much of how an air conditioner or refrigerator moves heat via a refrigerant such as Freon, etc. This energy is important in matters of climate and weather, mold in basements, human comfort in buildings, internal combustion engines, etc. The large numbers of people who ignore it, and stubbornly stick to the original three, probably parallels ways in which people don't understand the forces that move markets.

Philip J. McDonnell adds:

I truly enjoyed Mr. Gifford's description of the three fountains in Central Park at the recent Spec party. He truly enjoys an admirable intuitive insight into fluid dynamics.

He writes:

I think convection is a transfer of mass, not heat, which is where I diverge from the mainstream.

In this matter I must respectfully demur, at least in part. My perception of convection is that it is BOTH a transfer of heat and mass. If we consider something which I will call a relative "hot spot" (without proper definition), then all of the molecules in the hot spot will tend to have higher kinetic energy (velocity) and the net result will be to push the hot spot outward. Thus the hot spot will tend to have a lower density and trivially a lower concentration of mass relative to adjacent areas. The hot spot will tend to rise because of its lower density. Thus the convection effect will carry both a lighter low density mass and the on average more energetic molecules higher in order to balance out the forces.

Mr. Gifford has truly nailed the concept of "change of phase". To increase the temperature of water from 27 to 28 to 29 to 30 to 31 degrees Fahrenheit requires a linear increase in energy for each degree. To go from say 31.5 to 32.5 requires dramatically more. The same physics holds true for the transition from liquid to gaseous state.

With respect to evaporation Mr. Gifford has a good point. When an individual molecule "boils away" it carries away relatively little mass but is effectively on the upper tail of the kinetic energy distribution. So more energy is dissipated while relatively little mass is lost. This explains why fans feel so good in the summer. This topic deserves more thought and I suspect holds many insights.