The Action-Reaction Model Another Trading Mistake

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The “Action-Reaction” Model: Another Trading Mistake

One of the first things many traders learn when they begin studying technical analysis is that the market moves before the economy. So why is it then, even when traders know this, that when good economic comes out traders assume the market will go up. This is the “action-reaction” model: if good economic news come out the market will go up. If bad economic news come out the market will go down. Have you ever made a trade following a supposedly good economic news announcement, only to watch the market fall instead?

The truth is, the price may sometimes do what we expect when news comes out, and sometimes it won’t. In other words, if you just trade off whether a news release was good or bad, it equates to basically rolling the dice and gambling. It is likely not a sustainable way to extract profit from the market.

The actual market (price) tells us what we need to know. You will notice that when a market, whether it be the stock market or a forex pair, is in a very strong overall decline, people seem to ignore good news. A great report may come out, and the price still drops. That is because the market is the leading indicator, and traders/investors are already letting everyone know what they think — “We need to sell!”

The opposite occurs during a very strong uptrend. As prices are rising strongly, a bad economic report may not even cause a slight pullback. Once again, this is because the market is a leading indicator. Traders and investors are buying, and some report that says what happened a month or two ago isn’t going to sway market participants from buying as much stock as they can.

Now of course there may be immediate volatility surrounding a news release, and it is very common to hear news anchors or even financial analysts rationalize price moves in terms of news. Right after an economic news release you may see a headline state something like “Market falls following disappointing labor data.” But 10 minutes later the market is back up! Trying to rationalize via news releases is not a viable way to trade.

But unfortunately we can’t even say the market always does the opposite of what news would indicate either. Sometimes a market does what you expect off a news release and sometimes it doesn’t. Here is an expert from an article entitled The Stock Market is Not Physics: Part II which looks at this phenomenon.

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The four-year period from March 1976 to March 1980 had not a single down quarter of GDP and included the biggest single positive quarter for 20 years on either side. Yet the DJIA lost 25 percent of its value during that period. Had you known the economic figures in advance and believed that financial laws are the same as physical laws [action-reaction], you would have bought stocks in both cases. You would have lost a lot of money.

Or suppose you knew that inflation would triple over the next 20 years. Would you buy gold? Many people believe that an increase in inflation always pushes up gold prices, so the gold acts as an inflation hedge. While this is true sometimes, other times it isn’t. Between 1980 and 2000 gold lost more than half its value while the money supply increased three fold due to inflation. News doesn’t predict prices.

The Bottom Line

So why do you need to know this? Because there are a lot of people out there, especially on the news who have never placed a trade in their life, that are going to tell you what to do based on some recent news release. They may not tell you what to do directly, but what they say plants a seed. A headline like “Market drops on lower than expected employment numbers” gives you the idea that next time lower than expected employment data comes out you should sell. But that may not be the case. Trading off news is a crap-shoot, because it is almost always historical in nature, and the market is a leading indicator.

So what is a better way to trade? Avoid the news, don’t listen to it. When you know a news release is coming out, step aside from the market as there is likely to be additional volatility, and weird moves which you can’t predict (based on the people who think they can predict based on news, and are losing money). Then the news release is over, step back in and trade trends based on your technical strategy. In other words, trust price and your charts. They don’t lie, and they tell you all you need to know.

Piling On Evidence Won’t Change Your Trading Odds

Which has a greater chance of happening?

A stock going up?

A stock going up because hedge funds are buying it in the belief that earnings are going to be much higher than expected?

In trading we deal with probabilities, yet humans, even many statisticians who (are supposed to) know this stuff inside and out, struggle with probabilities in daily life.

The stock going up is the more probable outcome, because it could go up for hundreds of reasons, while the hedge funds buying it up based on big earnings potential is only one of those hundreds of reasons.

While most of us nod our head in agreement once we find out, it is extremely hard to get away from.

Almost every analyst we see on CNBC or read online gives their outlook (up, down or sideways) for a stock or forex pair and then proceeds to explain why. We need to understand that the reasons (nearly all the time) given don’t improve the odds of the stock rising (To see how market truisms are often wrong, see: The “Action-Reaction” Model: Another Trading Mistake)

Even if the stock does rise it may not have risen for the reason the analyst gave. The analyst could have given an elaborate explanation about rising earnings, RSI readings and Bollinger Bands, but the stock actually went up because I spilt coffee on my keyboard and in cleaning it up accidently bought 100,000 shares which caused other traders to think a major player was starting to buy the stock, and so they started buying themselves.

There is one major take away from this, and also a caveat.

The major take away is that the simplest explanation is the most powerful, because it encompasses all explanations which are more precise. Simply saying a stock will rise has a greater probability of occurring than explanation as to why it will rise.

Here’s the caveat. Certain types of evidence do seem to strongly correlate with better than average trading returns. Think of it like a court room. If a man is on trial for murder and a witness says “I only saw it was a man who killed her” doesn’t add much evidence that it was this man on trial. His DNA at the crime scene may be a crucial piece of evidence though.

So we need to always ask ourselves (whether in our own trading, or watching someone on the news), “Is the evidence being presented actually relevant to the case being made?”

In order to figure that out, you need to test. Do RSI overbought and oversold levels really help you make better trading decisions? Test it out, or find someone that has. Are candlestick chart patterns reliable? Look for stats to back it up. Only then do you know if it is valuable evidence for discerning stock prices and making profitable trades.

Do this for a number of indicators and you’ll find that very few will help you with your trading. Most indicators react to price, their calculations have absolutely no predictive qualities written into them.

Now there do seem to be some things I have found which tend to turn prices, with slightly better than average odds. By combining support and resistance (usually diagonal in the form of trend channels), trading in the direction of the trend, and occasionally watching Fibonacci Retracement levels related to those trades, I am able to pick some advantageous entries. Yet even so this is a slight edge, which I exploit by taking lots of good set-ups in multiple forex pairs so that most work out, but a few won’t. I don’t know which ones won’t work though, which I why I take as many good set-ups in different pairs that I can.

Final Word

Don’t get drawn in by other traders giving you all sorts of reasons for why a stock or forex pair will go up or down. Only price tells the real story, so watch price. Most “evidence” may not even be correlated to better than average returns, but because someone said it, and it seemed to make sense, it is repeated over and over again. It could be a total lie, but no one has bothered to refute it. Even if a strategy/evidence works for someone else, you don’t know if it will work for you. So test things out for yourself before relying on someone else. Piling evidence, especially when most of it is BS, won’t improve your odds of trading successfully.

Action-Reaction

Discussion

Lex. III. Law III.
Actioni contrariam ſemper & æqalem eſſe reactionem: ſive corporum duorum actiones in ſe mutuo ſemper eſſe æqualis & in partes contrarias dirigi. To every action there is always opposed an equal reaction: or the mutual actions of two bodies upon each other are always equal, and directed to contrary parts.
Quicquid premit vel trahit alterum, tantundem ab eo premitur vel trahitur. Si quis lapidem digito premit, premitur & hujus digitus a lapide. Si equus lapidem funi alligatum trahit, retrahetur etiam & equus (ut it dicam) æqualiter in lapidem: nam funis utrinque diſtentus eodem relaxandi ſe conatu urgebit equum verſus lapidem, ac lapidem verſus equum; tantumque impediet progreſſum unius quantum promovet progreſſum alterius. Si corpus aliquod in corpus aliud impingens, motum ejus vi ſua quomodocunque mutaverit, idem quoque viciſſim in motu proprio eandem mutationem in partem contrariam vi alterius (ob æqualitatem preſſionis mutuæ) ſubibit. His actionibus æquales fiunt mutationes, non velocitatum, ſed motuum, (ſcilicet in corporibus non aliunde impeditis). Mutationes enim velocitatum, in contrarias itidem partes factæ, quia motus æqualiter mutantur, ſunt corporibus reciproce proportionales. Whatever draws or presses another is as much drawn or pressed by that other. If you press a stone with your finger, the finger is also pressed by the stone. If a horse draws a stone tied to a rope, the horse (if I may so say) will be equally drawn back towards the stone; for the distended rope, by the same endeavor to relax or unbend itself, will draw the horse as much towards the stone as it does the stone towards the horse, and will obstruct the progress of one another as much as it advances that of the other. If a body impinge upon another, and by its force change the motion of the other, that body also (because of the equality of the mutual pressure) will undergo an equal change, in its own motion, towards the contrary part. The changes made by these action equal, not in the velocities but in the motions of the bodies (that is to say, if the bodies are not hindered by any other impediments). For, because the motions are equally changed, the changes of the velocities made towards contrary parts are inversely proportional to the bodies.

(Newton, interpreted by Elert)

For every action there is an equal and opposite reaction.

A force is an interaction between objects.

  • forces always occur in pairs (action-reaction, arbitrary assignment)
  • same type (normal-normal, tension-tension, friction-friction, etc.)
  • same magnitude (why? because!)
  • act on different objects (object pairs)
  • in opposite directions (obvious, hopefully)
  • have different effects (acceleration is inversely proportional to mass)

The third law is often misinterpreted. Action and reaction are exerted on different objects and so don’t cancel. When two bodies interact, they exert equal and opposite force on each other.

A famous example of a mistake.

That Professor Goddard, with his “chair” in Clark College and the countenancing of the Smithsonian Institution, does not know the relation of action to reaction, and of the need to have something better than a vacuum against which to react — to say that would be absurd. Of course he only seems to lack the knowledge ladled out daily in high schools.

For every expert, there is an equal and opposite expert.

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