Volatility Reflexivity & Mean
ReversionMark Whistler
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Volatility Reflexivity & Market PsychologyIndicator Failure | Information Failure
Market Understanding Failure
Volatility
Reflexivity
Volatility
Defined
Probability
Volatility
Trading Mean
Reversion
Four Types of Volatility Defined Market Volatility | Price Volatility | Period-Mean Volatility | Probability Volatility
Probability VolatilityVolatility Expansion = Trending
Volatility Compression = Lateral Trading
Mean ReversionTwo Types of Mean Reversion
Identifying Opportunity
● We must first be willing to think critically (with an open mind) about
why what we’ve been told is reliable- Is truly reliable.
● We must check the math.
● We must not accept vague terms like “overbought and oversold.”
● We must be willing to consider the possibility that 95% of the
information, media, analysts and economists present is wrong.
We Must Then Be Willing to Deconstruct Everything We Know...● We must be willing to put in the time-
● We must have a thick skin-
● We must be willing to consider the fact that the information
believed to be true, may have been
bad from the start...
We Must Be Willing to be Patient While Putting the Pieces Back Together..
To Unlock the Mystery)
First Piece of the Puzzle to Unlock)What is Volatility Reflexivity?
Volatility Reflexivity
• The imperfect understanding of
markets and trading by individuals,
media, and professionals creates
volatility...
• "Volatility" is really opportunity and can
be spotted through generalizations.
• "Human understanding is often incoherent
and always incomplete."
• "People base their actions not on reality but
on their view of the world. And the two are not
identical."
• "Therefore, outcomes are liable to diverge
from people’s expectations."
• "Events that have thinking participants cannot
be understood without taking that divergence
into account."
George Soros and
Reflexivity
Influenced by Karl PopperPopper's Model of Analytical Science
Initial Conditions
GeneralizationsFinal
Conditions
Initial Conditions
Confirm Outcome
Generalization must be TRUE
The Problem
with Popper's
Model
The Theory of
Generalizations
Overbought
and
Oversold
1. An asset that has experienced sharp upward movements over a very short period of time is often deemed to be overbought. Determining the degree in which an asset is overbought is very subjective and can differ between investors.
2. Technicians use indicators such as the relative strength index, the stochastic oscillator or the money flow index to identify securities that are becoming overbought. An overbought security is the opposite of one that is oversold.1
Investopeida.com
Defines Overbought as...
Influenced by Karl PopperPopper's Model of Analytical Science
Initial Conditions
GeneralizationsFinal
Conditions
Market Rally Stochastics
Overbought
Selloff
Pending
Reversal
For Example...
What if the Final Conditions
are not met though?
• When we depend on generalizations, we can never question the generalization that was the vehicle linking our expectations to the outcome... Otherwise, we would see the GENERALIZATION was the problem from the start...
• So we look at everything else that could have been the problem... Except the problem itself...
• The Generalization...
Why Generalizations are so Harmful!
Initial Conditions
AKA Expectations
Must Have Vehicle
"Generalization"
To Link Our Expectations to the
Outcome...
When Trying to Figure Out What Went Wrong?
How We Most Often Perceive Markets and Trading...
Fact Fact Fact = Outcome
We commonly believe information, trading opportunity, technical events, trends, etc... Move in a logical, sequential flow...
For example, "When Stochastics trade above 80, the currency must be overbought, and thus, a reversal is pending..."
But this type of thinking fails to consider how higher prices might change some traders opinion to: Higher prices mean the currency is breaking out to a new range, or the beginning of a trend...
Theory of Reflexivity
= Outcome
"The actual course of events is likely to differ from the
participants’ expectations and the divergence can be
taken as an indication of the participants’ bias."
Fact
Perceptions
Fact
Understanding
Expectations
The Alchemy of Finance | George Soros | Page 41
Passive Function• The situation is influenced by
the participants perceptions...
• Example: Higher prices may lead participants to perceive a "breakout" and thus, take positions long... Which, in-turn, drives prices even higher...
Imperfect Thinking (Perceptions) of
Market ParticipantsHow Participants Are Influenced By and also Impact Markets
Cognitive Function• Participants Perceptions Are
Dependent on the Situation
• Example: One may not consider
taking a position long, unless an
upward trend were in place.
Volatility ReflexivityWe must take another step beyond Soros' Theory
of Reflexivity, to remain clear, balanced, and
profitable during stressful short-term trading...
Step 1
Unlinking Our Expectations
from the Outcome
• We must cognizant of our own thinking and
emotions, constantly asking ourselves if we have
possibly linked our expectations to the outcome...
• If we have, we must ask ourselves if our
perception of reality has become skewed, or
biased, based on the fact that we are expectant
of a particular outcome...
• If we find we have linked our expectations to an
outcome, we must identify the Generalization (the
vehicle), which may be causing the problem...
Step 2
Separate Facts from
Perceptions of Broader
Market...
• Ask ourselves if price is influencing perceptions,
or perceptions influencing price?
• Ask ourselves if perceptions are being influenced
by facts, or perceptions?
• Step back from the situation and attempt to
"weight" the situation in-terms of "expectations
aligned", or "uncertainty persists" within markets.
Step 3
Be Fully Prepared to
Change Our Minds, Should
the Situation Warrant Such...
• If we have linked a perception (expectation) to an outcome, and we have identified such... We must ask why we have linked our perception to the outcome?
• We must then ask what other possible information we might be (consciously or unconsciously) ignoring, to keep our expectations cheerfully linked to the outcome....
• Be prepared to close our position (winner or loser) should the facts | perceptions show our expectant outcome is likely flawed...
Analyze FactsFundamentals, News, Politics and Technicals
Analyze Perceptions
Both Our Own and That of Other Participants
Are Perceptions Biased or
Warranted?
Analyze ExpectationsAsk Where Facts and
Perceptions May be Linking Expectations to an Outcome
Is Price Influencing
Perceptions, or are
Perceptions Influencing
Price?
Is There Really Opportunity or
Risk Right Now?
Price Influencing Perceptions• Can be both retail and institutions
• Most often though, technical signals are a derivative of price influencing perceptions... Meaning, retail traders are reacting to price movements...
Perceptions Versus Price
Perceptions Influencing Price• Can be both retail and institutions
• Most often though, perceptions influencing price
are institutions seeing risk, or potential future
value gain or loss, and are taking action
Another Piece of the Puzzle
What is Volatility?
• As currently discussed, defined,
and thought of by media,
traders, and educators...
Volatility is a generalized term
covering erratic price action,
risk within returns, and/or fear
within markets...
• There are really four types of volatility...
• Most important thought, volatility is
probability...
Volatility for Active Traders
The four types of volatility that affect common trading and markets are:
1. Market Volatility
2. Price Volatility
3. Mean-Period Volatility
4. Probability Volatility
Volatility is
Not an
"all-encompassing"
word!
Market Volatility"The CBOE Volatility Index® (VIX®) is a key measure of
market expectations of near-term volatility conveyed by
S&P 500 stock index option prices. Since its introduction in
1993, VIX has been considered by many to be the world's
premier barometer of investor sentiment and market
volatility."
Price VolatilityPrice volatility is a both a cause of, and
derivative of market volatility, probability
volatility and mean-period volatility. While
price volatility is really nothing more than
an extra description of the total low-to-
high range of prices in any given period
measured, the label is required to
separate "price action" from the other
three volatility descriptions...
Mean-Period VolatilityMean period volatility is simply the paradigm where shorter-term distributions will likely show greater volatility than that of their longer-term counterparts. In addition, the shorter the period measured, the greater the volatility of the same mean measured. For example: A 50-period mean on 15-minute chart will show greater volatility than a 50-period mean on a 4-hour chart.
Probability Volatility• Total probability of potential Price
Volatility, Mean-Period Volatility at any
given moment.
• Influences and influenced by Market
Volatility
• Significant "real time" tool in helping us
identify opportunity or risk within
markets and trading...
Probability Volatility • Expansion and
Compression of
Standard Deviations
• Is a leading Indicator
• Specifically informs us of
"total possible
probability" at any given
moment...
Standard Deviations• Measurement of
Probability
• Expand and Compress
• Identify When Trending
is About to Begin, or
Lateral Trading is in
Effect...
Standard Deviations• Shape of distribution does not matter...
• Distribution (just like the mean) is not static, rather, it is dynamic like prices
and time...
• Probability remains intact, because the distribution moves AND standard
deviations (volatility bands) expand and contract...
Fatal Flaw of Assuming Static
Distribution...
Why Standard Deviations Expand and
Compress, and What the Occurrence Means!
Identifying Trending Versus Lateral Trading
Action...
To Trade With the Trend or Mean
Reversion?
Three Types
of Mean
Reversion
• Price action mean reversion occurs when random volatility strikes after a news announcement...
Price Action
• "Reload Mean Reversion" Occurs when Institutions Allow Prices to Fade Back to Mean in Order to Obtain a Better Fill
Reload Reversion
• Uncertainty, or Fair Value Mean Reversion Occurs in Lateral Markets and can be Spotted Through Volatility Compressing...
Volatility Compression Mean Reversion
Mean Reversion Opportunity
Probability Volatility Compression
Equals Mean Reversion Opportunity!
Don't Fear Lateral "Chop"
Anymore! It's Really Just
Volatility Compressing and is
Filled with Mean Reversion
Opportunity!
Questions?
Volatility Reflexivity & Mean
ReversionMark Whistler
Thank
You!
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