Reader question: why do patterns work?

A really interesting discussion developed in the comments to this post on pullbacks. Since you’re capable of clicking the link and reading the comments, I won’t copy the whole discussion here, but just some highlights:

Markus asked:

Adam, what I don’t understand is how such an obvious pattern like the pullback sustains for decades, especially in our times of more and more sophisticated algos. …authors mainly write that momentum has been such a consistent factor because it is rooted in our behavioral biases and that news takes time to be fully priced in. But this should change with a market becoming more and more traded by algos. …a lot has been published about momentum which might also be a harbinger for a shrinking edge regarding momentum strategies.
What do you think, why has been momentum and the pullback pattern so robust in the market?

Ian answered:

The algos focus more on the intraday timeframe. Their trades (along with the trades of humans) are the ones causing the “noise” in the price action. I am not putting blame here, just stating the fact which has been true even from the early days of financial markets. So given the above info, we need not worry about algos. One way to avoid them is to trade in a higher timeframe. I have found trading on the weekly timeframe to be cleaner/clearer from noise.

After more discussion, Markus answered his own question:

But my question is why it works so well…. The edge should get smaller if those trades become more crowded or it might vanish if the market gets more efficient. On the other hand, imagine good new hits the mkt and a stock rises. It cannot get his new “fair” value in an instant cause there are funds who have to buy 100ks of shares and they have to do it step by step… Perhaps this is the reason why momentum has been so persistent.

Let me extend the conversation with a quote from a section of my book that was called “Why small traders can make money”:

This is an obvious issue, but one that is often ignored. The argument of many academics is that you can’t make money trading; your best bet is to put your money in a diversified fund and reap the baseline drift compounded over many years. (For most investors, this is not a bad plan for at least a portion of their portfolios.) Even large, professionally managed funds have a very difficult time beating the market, so why should you be able to do so, sitting at home or in your office without any competitive or informational advantage? You are certainly not the best-capitalized player in the arena, and, in a field that attracts some of the best and brightest minds in the world, you are unlikely to be the smartest. You also will not win by sheer force of will and determination. Even if you work harder than nearly anyone else, a well-capitalized firm could hire 20 of you and that is what you are competing against. What room is there for the small, individual trader to make profits in the market?

The answer, I think, is simple but profound: you can make money because you are not playing the same game as these other players. One reason the very large funds have trouble beating the market is that they are so large that they are the market. Many of these firms are happy to scrape out a few incremental basis points on a relative basis, and they do so through a number of specialized strategies. This is probably not how you intend to trade. You probably cannot compete with large institutions on fundamental work. You probably cannot compete with HFTs and automated trading programs on speed, nor can you compete with the quant firms that hire armies of Ph.D.s to scour every conceivable relationship between markets.

This is all true, but you also do not have the same restrictions that many of these firms do: you are not mandated to have any specific exposures. In most markets, you will likely experience few, if any, liquidity or size issues; your orders will have a minimal (but still very real) impact on prices. Most small traders can be opportunistic. If you have the skills, you can move freely among currencies, equities, futures, and options, using outright or spread strategies as appropriate. Few institutional investors enjoy these freedoms. Last, and perhaps most significantly, you are free to target a time frame that is not interesting to many institutions and not accessible to some.

One solution is to focus on the three-day to two-week swings, as many swing traders do. First, this steps up out of the noise created by the HFTs and algos. Many very large firms, particularly those who make decisions on fundamental criteria, avoid short time frames altogether. They may enter and exit positions over multiple days or weeks; your profits and losses over a few days are inconsequential to them. Rather than compete directly, play a different game and target a different timeframe. As Sun Tzu wrote in the Art of War: “Tactics are like unto water; for water in its natural state runs away from high places and hastens downward … avoid what is strong and strike at what is weak.”

The short answer is that there is a lot in the market we don’t understand. I think Markus is asking the right kinds of questions: why do the edges we see exist in the first place, and why don’t they go away? In many cases, edges are fleeting, and they erode after research is published–I suspect many of the edges just were not very stable to begin with. We do, however, see a few underlying patterns in the market that have, literally, existed for all of recorded market history. Maybe they will change in the future, but it seems unlikely. In the case of momentum and pullbacks, markets do not instantaneously adjust to new price levels; markets move to new price levels, and they usually do so through a series of steps. We can (and should) speculate about why that is so, and questions about longevity of edges are always relevant. But, in this case, we have a pattern that works, that seems to continue to work, and it makes sense to figure out how to capitalize on it while we monitor it for signs of that pattern breaking down. Come to think of it, that’s a pretty good job description for a trader…


Adam Grimes has over two decades of experience in the industry as a trader, analyst and system developer. The author of a best-selling trading book, he has traded for his own account, for a top prop firm, and spent several years at the New York Mercantile Exchange. He focuses on the intersection of quantitative analysis and discretionary trading, and has a talent for teaching and helping traders find their own way in the market.

This Post Has 5 Comments

  1. A_Joe

    The Part of the Book Quoted by You in this Post is one of My Favourites in Your Book…. A Really Superb Perspective ! It should be among A Must-Read Information for any Trader….. Thank You for Reproducing it Here !

    1. Adam Grimes

      Good find and good article… but I don’t see that it applies to the types of momentum we see in different assets and different timeframes. That’s the problem with all explanations: they work, but it’s very hard to find explanations that cover all cases. Maybe it’s wrong to look for those overarching explanations, and maybe it’s actually a combination of many factors? Perhaps. Thanks for the link and for contributing to the discussion.

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