Wednesday, 9 January 2013

Anchoring all at sea

Imagine that the EUR/USD fx rate really does look like a random time series.  Pretend, if it helps, to imagine that the market right now is traded exclusively by algorithms, with no psychological human biases.  Those two major economic blocks, in long-term way, are probably going to be making similar sorts of macroeconomic decisions and monetary decisions - not necessarily in the same decade, but in general.  Being mature western pseudo-federal democracies, they'll probably mirror each other through time.  At least, pretend so for the purposes of this article.  It could be that the seeming randomness may be a martingale, with no discernible long term up or down drift.

Now, bring human beings into the trading picture.  Kahneman highlights a major behavioural bias of anchoring.  We like to compare potential gains or losses against certain reference points - be that the current state of wealth, a desired level of gold, a break-even stock price, we tend to evaluate risky ventures against these reference points.

But what happens when you're faced with a time series which seems quite random to you?  Where do you hang those anchors when you're out to sea?  First of all, there are anchors personal to one trader, around his p&l.  You might have an anchor in the form of a stop level which means he can't lose more than 1% of his AUM.  But his AUM is essentially a private fact.  Trader 2 will have a different AUM and so will have a disposition to construct private behavioural biases at a different point.  Similarly for the whole population of traders out there.  The best you can say is these biases are clustered around where the market is trading now.  So in a sense I would expect these personal anchors to be distributed, perhaps normally, about the current market level.  But certainly not concentrated or lumpy.

But there are two other shared set of exogenous, non-fundamentals based set of anchor possibilities right there in front of all N human traders in that market when they look at a chart of EUR/USD.

  1. The numbers on the chart's Y axis.  As human beings we tend to be drawn to big numbers - like when the year 2000 came around.  Or in FX when the USD/JPY hits 100.0.  And with FX there are layers of 'big number' anchors as you increase the number of decimal points.  Ie 100.100 would be more of an anchor candidate than 100.897.  And so on.  But if a significant fraction of those behaviourally biassed anchor-seeking traders implement, say, stop levels around big number levels in that market, then it'll have a real effect.  You may see more, or sometimes less volatility around these big numbers. You might see the market moving towards these anchors almost as a ship gets drawn to the rocks by the call of irresistible sirens.
  2. The traders also see the local history of the evolution of that random looking time series.  But in their desire to discover or invent anchors to help them with their trading decisions (when to get in, when to profit, when to call it quits on the trade) based on so-called support and resistance levels.  Even though these start   of as a kind of collective insanity or collectively expressed behavioural biases, again, the setting of those stop loss and limit orders have a real effect on the dynamics of that market.
So anchoring effects crystallising out from fantasy into reality can be at least partly explained by an all-pervasive human bias to attach anchors to the decision making process, even in the face of randomness, perhaps in this case especially in the face of randomness.  Additionally the same rather small set of anchor points are shared by the wider trading population since they're all positively re-enforcing the anchors which are indicated by the particular local evolution of that market price over the time horizon(s) of interest to traders.

As a trader, therefore, it would be wise to assume that these unjustified support and resistance effects, and big-number effects are real, become real.  The evolving positive feedback loop has a kind of performativity in the construction and realisation of support, resistance, big number 'attractors'.