Fundamental Laws, by Victor Niederhoffer

February 11, 2007 |

The moves in markets often seem to imitate the kinds of things we see in nature: in gas; in water; and in electricity. For example, the gentle back and forth of the stock market last week, gradually building up pressure and then exploding on the downside, is like a cork bursting from a bottle of champagne, or a volcano erupting.

In electronic circuits we often see a signal gently oscillating between set points, then gathering a slight bit of amplitude on one side or the other, and finally tripping the set point thereby triggering a major change in the output. In capacitor resistor circuits, we find the same buildup of charge, with little change in the output until the time constant of the capacitor is fulfilled and the output suddenly and dramatically changes.

The reason for these similarities is they are all results of various energy conservation laws. Energy coming into a system cannot just disappear. One major conservation law in electronics is Kirchoff's Current law. It holds that current going into the confluence of two wires equals the current coming out. Another major law is Kirchoff's voltage law. It states the voltage that's input to a closed circuit is equal to all the voltage used up in work in the circuit.

I find the major applications of conservation laws in markets relating to some input from outside a system. Usually, some information or money flow gets distributed to the various components, companies, and markets of the system. A major merger announcement affects not just one company but all companies related to it. An increase in liquidity in the system gets distributed according to market's laws similar to Kirchoff's laws in electronics.

Click here for information on Kirchoff's laws.

To be continued.

Philip McDonnell adds:

Two summers ago, in Central Park, the Chair said something to me which was at once profound yet seemingly too simple. "There is only so much money." That was all that he said. To someone who did not understand, it would seem rather sophomoric or even downright cryptic. But it was all he needed to say because I had read his books.

The statement referred to a simple conservation law much like the conservation laws of physics. In physics energy and mass are the most significant variables in most mechanical systems. So we have laws such as the Conservation of Energy, Conservation of Mass and Conservation of Momentum. In financial markets a similar law applies. Money is conserved. At any given time 'there is only so much money'.

Let us imagine an island economy where there are only two stocks X and Y. There is only so much money on the island. When the traders on the island decide they want to invest in X they need to figure out how to pay for the purchase. The only liquid source of money is stock Y. So they sell Y. The price of X goes up and Y goes down.

Let us draw this on an X-Y coordinate plot and assign some real numbers to it. The relationship between X and Y would show up as a line from high up on the Y axis sloping downward to some point of a large X value. Suppose the amount of money were $100. If everyone wanted to own Y and no one wanted X then we would have Y=100, X=0. Conversely if everyone wanted X and not Y then Y=0 and X=100.

We can think of the distance of the current market valuations as the distance from the origin that is equal to the buying power of the money. It is a simple conservation law on our island. The $100 defines a radius from the origin. It thus defines a circle. It is easy to draw on a two-dimensional chart or even in 3D. Drawing a 5000 dimensional sphere for the 5000 actively traded stocks is a project still in progress.

Charles Sorkin adds:

Is it not the beauty of Eurodollars that since there is no reserve requirement (being out of the country and not under the auspices of the Fed), foreign banks can create and loan as many dollars as they want?

Gregory van Kipnis adds:

Not quite. After the Eurodollar blew up in 1974, central bankers convened at the behest of the Bank of England to put a lid on the runaway growth of the Eurodollar market. It was agreed that each CB would be responsible for defaults of the banks they regulate even if the default were in the Eurodollar market. Following that, each foreign CB put reserve requirements on Eurodollar deposits.

From: George R. Zachar:

Not quite. After the eurodollar blow up in 1974 of Bank Herstadt, central bankers convened at the behest of the Bank of England to put a lid on the runaway growth of the eurodollar market. It was agreed that each CB would be responsible for defaults of the banks they regulate even if the default were in the eurodollar market. Following that, each foreign CB put reserve requirements on eurodollar deposits. /Gregory van Kipnis/

Given

1) That central banks are increasingly players themselves,

2) The clubby incestuous relationships within the govt/bank community in places like Italy,

3) The fact that one major central bank has had a high official murdered by someone he regulated (Russia),

4) The asset explosion in nations whose financial infrastructure hasn't been tested (the Gulf States),

5) The nil possibility that govt bankers grok the array and scope of derivatives…

I would not assume the central banking clerisy is on top of things. They might be, but there's reason for doubt.

Easan Katir writes:

The moves in markets often seem to imitate the kinds of things we see in nature… VN

To continue the Chair's analogy, it would seem the next practical question is how do we predictively discover the impedance of that market capacitor which discharged on February 8, provided the "3 of a kind," then tripped another point of capacitance and surged in the opposite direction for the past 4 days? What voltmeter can we use to measure the current passing through?

Or is this market more like a big kid bouncing on a "40-day moving average" trampoline for the past seven months?

Comments

2 Comments so far

Alan Millhone on February 12, 2007 11:17 pm
In 1967 Checker Grandmaster and Chess Master ,Mr. Newell W. Banks stayed several days at my home. He spoke of knowing Thomas Edison in Detroit (Mr. Bank’s life long home). Loved to have been there to listen to those two talk about board games and electricity ! Both men are departed but have left their mark forever on our culture.
William V. Weaver Jr. on February 15, 2007 4:12 pm
I find the comparison between market fluctuations and the laws of physics a bit unnerving. Reason being that in your hypothesis it becomes apparent that qualitative analysis is quite useless. When in my opinion it is the psychological interpretation of the qualitative analysis that produces technical trading rules. However I do understand the need for simplicity and where such laws do apply to the market. As for one, I myself create complex scenarios and deduct from them simple “rules” because they are easier to trade on and much more effective because they are simple.

Even for the most active trader who depends on AD lines, the breadth, trin, MACD, patterns and etc., there has to be at all times an understanding of what they are investing in. If one were to look closely they’d find that the ultimate motive for market trend happens to be human psychology and nothing more. Two recent examples of this are the market drop the Thursday prior to the last Fed. announcement, and then the market drop this past Friday that continued into Monday prior to the speeches this on Wednesday. It is my hobby to study patterns that are created around events and even more so to understand how the technical aspect relates to the fundamentals. In all “known” events I have found that there is a similar response from buyers and sellers prior to the event. In a situation where the market or a given security is higher than it’s short and long-term averages 5 days prior to an event one will expect a correction three days prior or two days prior. That window is much more accurate when used with earnings reports, but can be expanded further (earlier) when using the two events above that look at the market as a whole. What one will notice prior to the second event is that the markets were not following their seven-month trends and were in fact already “down” because of the first set of events. But if one looks more closely one will realize that prior to the second event the market had yet to retrace since the Fed. move, thus signaling a coming downtrend.

If one steps back, the sequence of events should be as follows prior to a known event:
When studying a known event one should look for two things, firstly a possible position that has within five days prior to the event reached new highs (zoom out of your chart to determine highs; highs do not always represent all time new highs but rather highs from a newly formed or currently existing trend) and has either yet to retrace itself, or has partially retraced itself but has yet to reach it’s nearest level of resistance. Secondly one has to find a level of resistance that is not “strong” but rather easily identified. That is where psychology comes into play. You don’t want to find a level where just the professional traders will react, or just the individual traders will. One wants to find a company with a level of resistance that everyone will adhere to. Scanning the markets for such a situation is not very hard as known events appear in packs of hundreds every day. Once a good situation is found the trader must only place a limit order two cents above the floor. It would not be smart to invest in a security trading below $6 of any currency, or with less than 200,000 shares traded daily (there is a nice algorithm but that will remain a secret for now) primarily because of gaps, and exit points; if you won’t have an exit… Why bother? The two cents rule is used to a) stay away from provoking a break in trend, and b) to insure that one’s order is filled.

Once this has been done the trader must understand exit points. If the event will happen after the market close the following day it is always smart to place an extended hours selling price much above what you paid for it; incase you get lucky. With AMC’s one should always stick it out as long as possible and in some cases depending on risk tolerance (for example if a report is to be announced at 5pm) hold the position into extended hours and try to gap the price up with a stick and carrot trade order. Just because insider trading is illegal doesn’t mean it’s not done… And if someone thinks you know something, even if you don’t you can always bluff and raise them to a price you feel comfortable selling at.

BMO’s are another subject. BMO’s tend to have rallies towards the close (just like AMC’s) but also tend to sell off just prior to the bell, within the last three to four minutes. Because of this one can lose an entire day’s gains if they do not exit a position before this sell off. If you follow the reversal periods there are four times that are good to buy into following day BMO’s: a) Before the market opens if there is a strong gap down, which doesn’t usually happen unless it was the day before, b) 10am just after a large sell off, however most positively regarded stocks will do just the opposite, c) during the two pm reversal period which could be a correction from a gap up earlier in the day, or d) if your risk tolerance is very high you could get in directly prior to the bell during a sell off and exit extended hours the same way described above for AMC’s. This is very risky because as you scale up one will find it harder to find buyers and if you don’t exit your position you’ll be forced to endure the event, which could go either way.

Though no trader can tell which way an event will go when looking at it from much in advance, the numbers as the event occurs can give you just that. That’s an algorithm I cannot share but does support the hypothesis that market fluctuations do revolve around quantitative analysis. Or does it? See once again everything I just described tells of psychology… the sell off of unsure investors prior to news… the reversal of the corrective trend as buyers find prices they like… and of course, the most speculative bet of all: the resulting direction of a trend post event. Technical analysis and any such laws all work because of psychology, it’s that simple.

For a good example of all of the above look at ONXX since Monday the 12th. It has an earnings report that comes out today, and even with the announcement that it can prolong the lifespan of liver-cancer patients this past Monday, it still strictly follows the above rules… I can’t wait to see if the speculators value it as being over hung with the earnings report after it’s 96% jump on Monday. Oh and if you’re curious how I did on that trade, ask Bill Rafter. I told him buy short at 25.36 on Wednesday… I sold at 24.10 today.

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