Springy Markets, by Nat Stewart

October 14, 2006 |

The other day while otherwise occupied, I found myself straightening a paperclip and wrapping it in a coil pattern around a ball point pen. The end result was a small, impressive looking coil spring.

Pressing it in my fingers a few times, (ok, more than a few) I started thinking about why a coil spring seems able to bounce back from greater pressure than strait wire, or wire bent in other configurations. My thought was, the pressure is more evenly distributed over a larger area, which creates less stress on any specific area, allowing the coil to handle more pressure before permanently deforming. Regardless, this sent me to the internet curious about the mechanics of coil springs.

This leads to Hooke's law which states that the amount by which a material is linearly related to the force causing the deformation. According to Wikipedia:

Hooke's law only holds for some materials under certain loading conditions. Steel exhibits linear-elastic behavior in most engineering applications; Hooke's law is valid for it throughout its elastic range (i.e., for stresses below the yield strength). For some other materials, such as Aluminum, Hooke's law is only valid for a portion of the elastic range. For these materials a proportional limit stress is defined, below which the errors associated with the linear approximation are negligible. Materials such as rubber, for which Hooke's law is never valid, are known as "non-hookean". The stiffness of rubber is not only stress dependent, but is also very sensitive to temperature and loading rate.

What would be the market's elastic range or elastic limit, and how would it be defined? Relative short term highs and lows come to mind. Perhaps distance off a reference point, like the opening range concept, or opening of week, or month, or yesterday's close, or x periods ago. Would the elastic range for markets be different depending upon if the market is being stretched in the direction of long term drift, or in Abelson's direction?

Are the elastic properties of market prices more similar to (using above examples) steel, aluminum, or rubber? If they're like steel or aluminum, how could the useful range appropriate to reversal trading applications be defined? If like rubber, what would be the equivalent of temperature and loading rate? Perhaps interest rates (or change in rates) and a measure of rate of price change?

If one can identify or approximate the elastic range, where would be ideal buy/sell points? Too far out, and risk price exceeding the elastic limit. Too close, and one suffers though the trough of the elastic range, perhaps selling to soon out of relief, missing the upward spring. Never a perfect balance, however.

If the analogy is at all valid, are there different time scale coil springs in the market? For example, if a short term (small) coil has exhausted its elastic limit, but the intermediate range (large) coil is still within its elastic limit, would this have any impact on how to manage positions? Would such thinking risk, "turning that short term loser into a position trade" which all books say is a bad idea. Is it? If not, or if so, by what criteria?

If one turns the coil spring on its side and traces the up and down pattern, it makes a perfect cycle of highs and lows. If one were to pull the most recent coil beyond the elastic limit, the horizontal distance would increase, and the extremes would fail to meet the extremes of previous coils. Over specific durations of time, is there an expected periodicity between short term highs and lows based prior highs and lows? If such highs or lows have not been made within a calculated 'elastic range" does this anticipate a change in cycle, or an anticipated move beyond the recent elastic limit?

If one finds oneself in a trade that relative to intended time horizon has exceeded the expected elastic range, would shifting exit horizon or targets yield a better result?

Ryan Maelhorn responds:

If you stretch a coil spring too far it essentially becomes worthless. It turns back into mere wire. The 1999-2000 bubble could be seen as a ruining of the coil that took years to "fix." Price is what separates the elastic range of stocks. Stocks under $0.10 can gain or lose 500% in a single day, whereas the DJIA is said to have a huge rally if it climbs 3%. Also, if you pull the coil out somewhat and let it go, it will not only go back to its natural state, but compress slightly, and then stretch out just a tad before coming to rest. When penny stocks lose 50% or so from the open of the day, usually there will come a time during the day when they will bounce back slightly, perhaps as much as 20%, before continuing their decline. A move you wouldn't even see if you were only looking at daily price bars.


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