Eclipse Technologies

Today I want to explore the implications of self-fulfilling prophecies in markets, trading, and investing to see what we can learn, and how we can potentially apply it when designing algorithms or other trading strategies.

There’s a concept in psychology known as a self-fulfilling prophecy. Here’s the definition from Wikipedia: A self-fulfilling prophecy is a prediction that comes true at least in part as a result of a person’s or group of persons’ belief or expectation that said prediction would come true. Essentially, your mere belief in something makes that thing more likely to manifest in the real world. For example, if you believe you are going to fail a test- you make it more likely that you will fail because your mind subconsciously arranges its thoughts, and, as a result, your actions, in a way that sets you up for failure. This also works the other way around- if you believe you will pass a test, you’re more likely to engage in thoughts and behaviors that help you pass, such as studying, going to sleep early the night before, etc.

In truth, most of our human systems function solely due to this concept. Money itself has value because we all agree it has value, and put our trust in the financial industry to safeguard and uphold that value. Expectations of the future lead to changes in demand for assets, with buyers and sellers attempting to anticipate future price movements. In fact, it is the mere anticipation of future price movements that causes these very price movements. If the majority of investors in a stock expect said stock to fall in value, most of them will sell it to avoid losses, causing its price to fall.

Self-fulfilling prophecies are fairly easy to detect in trading. In the industry, we have ways to measure price impact– the adverse effect of our own orders on the profitability of our trade. If we expect stock ABC’s price to increase by a dollar, but our own orders push the price up by 25 cents, we’ve lost out to ourselves because of our own expectations- this is the self fulfilling prophecy working against us.

Alternatively, technical patterns and signals often work because traders believe that they will work. For example, if only one trader sees a bullish wedge forming and acts on it by buying the stock, it’s unlikely that anything significant would come from the trade. The higher the number of traders that believe the bullish wedge is in fact bullish and valid (meaning it will result in a worthwhile movement in price), the more traders will act on it by buying, expecting price to increase. Many traders do not consider this, but it is their own orders that cause the price increase they are anticipating, since other traders are waiting for the volume and price action that earlier orders create in order to enter the same trend- even after the bulk of the move has already occurred. In this sense, trends are most worthwhile to enter just before the largest number of participants “believes” in them. In the future, I’d like to explore methods of measuring how the number of “believers” changes over time. *Note: “believers” refers to the overall long/short bias of traders (automated or human) at that moment in time.

This brings me to the concept of “price cascades”, often referred to as sell-offs, short squeezes, gap (up/down), etc. These fast moving price changes are all caused by the same thing- the overwhelming belief that the majority of market participants is acting, or will act in the same direction that you are/ will be positioned.

Another less easily defined example is mean reversion. Mean reverting behavior in assets can be statistically measured and proven to exist. But the reason behind why certain asset prices mean revert is equally important. To have a sound strategy, there must be a legitimate reason for why mean reversion occurs; it cannot be based on a self-fulfilling prophecy (the belief of other market participants that the asset prices are mean reverting, which causes them to buy(sell) the assets as their prices diverge, which results in the prices reverting to their means). This phenomenon is one reason why certain outstanding strategies experienced total failure after the self fulfilling prophecy that made them profitable ceased to exist, and the proverbial house of cards came tumbling down.

Self-fulfilling prophecies drive markets. The goals for creating new strategies then, might not be to try to predict how an asset price will move, but to predict what other market participants will believe in and act on over a given period of time (regardless of fair value). I will note though, that I believe the truth (fair value) does sometimes prevail eventually, but we must remember that the market can remain irrational longer than anyone can remain solvent.

Regardless of fundamental facts behind their investment choices, investors would be wise to factor self-fulfilling prophecies into their decisions, and to explore their use in future strategies.