Why do I see "Trends" in Randomly Generated Data?

R

Rahula

I've created an excel file I call "random chart generator". The weird thing is that most of these charts look exactly like market charts and you can apply all kinds of TA tools like moving averages, and trendlines to these charts.

If you don't believe me, see for yourself. Type in =RAND()*(-1-1)+1 into excel in column A. Then create a rolling sum of column A in column B. Then create a chart based on column B values and add a moving average.

Now what to make of this? I suppose when most people see a 7,7,7,7,7,7 result in the lottery they see a 'trend' even though it is just as random as 23,42,11,14,33,8 lottery result - both events have an equal probability of happening.

Now if the markets are random and the market closed up,up,up,up,up,up,up,up,up,up,up,up 12 days in a row - most people would likely be talking about it as a n-sigma event or a "black swan" even though it is just as unique and random an outcome as a up, up, down, up, down, down, down, up, down, up, down, down 12 day series of closes.

Now doesn't a random market assumption mean that both mean reversion and trend trading strategies don't have any science to back it up and at the end of the day it all comes down to luck?

I know, scary thread.
 
Why do I see trends?
From my notebook of thoughtful quotes, that I agree with, found on the web:
1/25/2005
The Clustering Illusion, by GM Nigel

One of the main enemies of the chess player (and indeed mankind) is in attempting to associate outcomes of individual games with certain behavior, when in fact no pattern existed. So we end up jumping around nervously from one idea to another (often regarding the opening, lucky pens or shirts etc) when in fact it was just father random at work.

"The clustering illusion popularly refers to the natural human tendency to "see patterns where actually none exist." Since according to a branch of mathematics known as Ramsey Theory complete mathematical disorder in any physical system is an impossibility, it may be more correct to state, however, that the clustering illusion refers to the natural human tendency to associate some meaning to certain types of patterns which must inevitably appear in any large enough data set."
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Recently described in a book titled "Mean Markets and Lizard Brains" by Burnham; he describes the natural desire to find patterns where no pattern exists.
...Professor Skinner gave pigeons food without attempting to reinforce any particular behavior. In fact, he gave the pigeons food 'at regular intervals with no references whatsoever to the bird's behavior.'
The outcome of this experiment was superstitious pigeons.... the pigeons attempted to make sense of the outcomes.... One bird was conditioned to turn couter-clockwise about the cage, making two or three turns between reinforcements......Each pigeon developed its own superstitious behavior..... The point is that our 'lizard brains' seek a logical pattern to illogical behavior.
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However, building a 'superstition' around signal analysis and cycles can be fun if not profitable.
 
you see trends in random data because even in random events, the same thing will by chance happen over and over thus creating what looks like a trend, a trendline, etc.

human auctions aren't random though.
This will turn into another thread where losers bash "ta", then degenerate gambler wannabe traders who use stochastics and moving averages defend it, then the bashers who are smarter than the gamblers yet not smart enough to be traders feel vindicated in their theory that no one can make money in the market from price alone (because they couldn't when they tried) by seeing the stupidity posted by the suckers and scream about how random the market is.

the market can be random at times, more often then not I have no idea what's going on. But even in those times, I can know that it's trading too randomly for me to find an edge. And just becuase I can't see it doesn't mean someone else can't.

stock charts have a few key differences than random up/down sequences charted... they can look a like, but looking at a very large sample the differences are clear.
 
slacker - nice post. You reminded me of another thread with this post:


Quote from fhl:

Here are some common thinking errors that impact your trading:

1) Confirmation Bias

The confirmation bias is a tendency to seek information to prove, rather than disprove our theories. The problem arises because often, one piece of false evidence can completely invalidate the otherwise supporting factors.

Consider a study conducted by Peter Cathcart Wason. In the study, Wason showed participants a triplet of numbers (2, 4, 6) and asked them to guess the rule for which the pattern followed. From that, participants could offer test triplets to see if their rule held.

From this starting point, most participants picked specific rules such as “goes up by 2“ or “1x, 2x, 3x.” By only guessing triplets that fit their rule, they didn’t realize the actual rule was “any three ascending numbers.” A simple test triplet of “3, 15, 317“ would have invalidated their theories.

2) Hindsight Bias

Known more commonly under “hindsight is 20/20“ this bias causes people to see past results as appearing more probable than they did initially. This was demonstrated in a study by Paul Lazarsfeld in which he gave participants statements that seemed like common sense. In reality, the opposite of the statements was true.

3) Clustering Illusion

This is the tendency to see patterns where none actually exist. A study conducted by Thomas Gilovich, showed people were easily misled to think patterns existed in random sequences. Although this may be a necessary by product of our ability to detect patterns, it can create problems.

The clustering illusion can result in superstitions and falling for pseudoscience when patterns seem to emerge from entirely random events.

4) Recency Effect

The recency effect is the tendency to give more weight to recent data. Studies have shown participants can more easily remember information at the end of a list than from the middle. The existence of this bias makes it important to gather enough long-term data, so daily up’s and down’s don’t lead to bad decisions.

5) Anchoring Bias

Anchoring is a well-known problem with negotiations. The first person to state a number will usually force the other person to give a new number based on the first. Anchoring happens even when the number is completely random. In one study, participants spun a wheel that either pointed to 15 or 65. They were then asked the number of countries in Africa that belonged to the UN. Even though the number was arbitrary, answers tended to cluster around either 15 or 65.

6) Overconfidence Effect

And you were worried about having too little confidence? Studies have shown that people tend to grossly overestimate their abilities and characteristics from where they should. More than 80% of drivers place themselves in the top 30%.

One study asked participants to answer a difficult question with a range of values to which they were 95% certain the actual answer lay. Despite the fact there was no penalty for extreme uncertainty, less than half of the answers lay within the original margin.

7) Fundamental Attribution Error

Mistaking personality and character traits for differences caused by situations. A classic study demonstrating this had participants rate speakers who were speaking for or against Fidel Castro. Even if the participants were told the position of the speaker was determined by a coin toss, they rated the attitudes of the speaker as being closer to the side they were forced to speak on.

Studies have shown that it is difficult to out-think these cognitive biases. Even when participants in different studies were warned about bias beforehand, this had little impact on their ability to see past them.

What an understanding of biases can do is allow you to design decision making methods and procedures so that biases can be circumvented. Researchers use double-blind studies to prevent bias from contaminating results. Making adjustments to your decision making, problem solving and learning patterns you can try to reduce their effects.

from http://www.lifehack.org/articles/lifehack/7-stupid-thinking-errors-you-probably-make.html
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I think it would be extremely hard (maybe even against one's nature) to think without making any of the above errors.
 
Quote from marketsurfer:

yes, this is fact--people WANT to believe in the face of overwhelming evidence to the contrary. if you flip a coin 10 times and you get 10 heads in a row, are you in a heads trend??



regards,

surf

http://www.elitetrader.com/vb/showthread.php?s=&threadid=46620&highlight=trend+following+delusion
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Okay so lets say an equivalent of 10 heads in a row happens in the market you're asked to bet on the next outcome.

Suppose you believe trends (patterns) do exist and forecast a higher probability of the trend continuing. Then the correct action is to trade the trend.

Now suppose you believe trends don't exist OR trends do exist and have no predictive value. Now the correct action is to not act play the random game at all.

Therefore mean reversion strategies aren't worth it under either assumption.
 
Quote from Rahula:

Okay so lets say an equivalent of 10 heads in a row happens in the market you're asked to bet on the next outcome.

Suppose you believe trends (patterns) do exist and forecast a higher probability of the trend continuing. Then the correct action is to trade the trend.

Now suppose you believe trends don't exist OR trends do exist and have no predictive value. Now the correct action is to not act play the random game at all.

Therefore mean reversion strategies aren't worth it under either assumption.
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correct.

it's only after one enters a position that trend has any significance, that being a personal one. prior to entry, its merely pretty lines on a screen.

surf
 
Quote from Rahula:


Therefore mean reversion strategies aren't worth it under either assumption.
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Let's say one guy has been buying a stock up all day. It's been in a range, there's a seller at 55.60 that doesn't want to break, and a buyer at 55.55. The futures start tanking really hard, the 55.55 buyer pulls his bids back to 55.40. Some people panic out. However, the seller wants to sell at his price, 55.60. The buyer wants to buy as cheaply as he can, but outside of the panic, isn't getting filled much at 55.40. you feel the selling drying up. You go long 55.43 playingg off the 55.40. The stock goes back into the 55.55-55.60 trading range. That's mean reversion. I just pulled that scenario out of my asshole but if it doesn't make sense to you you shouldn't be wasting money trading in a live human auction where you believe mean reversion has no value.
 
Quote from NY0BScalper:

Let's say one guy has been buying a stock up all day. It's been in a range, there's a seller at 55.60 that doesn't want to break, and a buyer at 55.55. The futures start tanking really hard, the 55.55 buyer pulls his bids back to 55.40. Some people panic out. However, the seller wants to sell at his price, 55.60. The buyer wants to buy as cheaply as he can, but outside of the panic, isn't getting filled much at 55.40. you feel the selling drying up. You go long 55.43 playingg off the 55.40. The stock goes back into the 55.55-55.60 trading range. That's mean reversion. I just pulled that scenario out of my asshole but if it doesn't make sense to you you shouldn't be wasting money trading in a live human auction where you believe mean reversion has no value.
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your talking tape reading, not seeing trends on a chart. right?

surf
 
I hate these kinds of threads and I don't know why I am posting. Nothing ever gets accomplished on either side of the argument.

Flipping a coin has nothing to do with markets. Markets are controlled by human emotions.

Human emotions cannot control a coin flip, but human emotions can be predicted.

Trends do exist and they are tradeable.
Profitably trading with high levels of consistency is not luck.
 
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