In the natural sciences a “phase transition” occurs when a physical object that can take variable values passes through certain critical stages and its behavior or the behavior of its constituent parts and processes undergoes a transformation or change in its morphological characteristics. In effect quantitative changes to the variable, i.e. changes that can be measured, produce qualitative changes in which the variable’s state changes so radically that it takes on entirely different qualities or attributes. The often cited example is the change in H20 as it changes from ice to water to steam or vapor.
We have seen for KLAC, INTC and AMGN (and the behavior is typical of most time series data for equities) that there is a transformational change in each stock from its “normal” behavioral characteristics (i.e. how it performs in the majority of circumstances when the intraday movements are less than ±4%) to how it behaves in the more extreme sessions that we analysed. These extreme sessions can vary from approximately 25% of the total trading sessions in the case of KLAC to less than 10% in the case of INTC. But in all cases there is phase transition taking place. The price dynamics that are characteristic of smaller intraday fluctuations show a random quality that is strikingly absent when range expansion and larger movements are taking place.
When we consider all of the data series it would appear that the closing bias acts in a random (i.e. independent and identically distributed) fashion. The closing position with respect to the intraday range is, by and large, equally as likely to be in any one of the decile ranges. But as the magnitude of the intraday directional change grows, traders’ opinions about the likely direction of prices begin to cohere, they become more and more aligned in their estimation of the near-term course of the market. There is a virtual unanimity of opinion that leads to a dramatic diminution of liquidity. Price takes the path of least resistance as even those who longer term do not subscribe to the prevailing view of the day, step aside to allow those in control of the agenda for that day to achieve their objective. During this trading session the market participants may have decided to suspend their usual fractious modus operandi (i.e. fading a trend after it reaches a certain point such as a moving average). This is not to overlook the fact that in the following session they may resume their more typical behavior or even decide to reverse the unidirectional nature of the previous session.
Why would normally argumentative and skeptical traders, who usually have very different views about the feasibility of the current price, decide to suspend their normal intraday tactics such as fading a price advance? This is a reformulation of the chapter’s opening question and to come closer to an answer to it we need to discuss the reflexive notion of price formation. The classic treatment of the reflexivity in financial markets was proposed by the great English economist J.M. Keynes in his epic work, The General Theory of Employment:
Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.
Once a certain price threshold is crossed (a tipping point) during intraday trading, the majority of market participants or average opinion begins to concur that for this particular day’s trading average opinion has already chosen today’s winner of the beauty contest. To use an expression taken from a totally different context but which can be adapted for the present purpose, it is as if for this trading session all have agreed that “There is nothing more powerful than an idea whose time has come.” But the cynic would be right to add “Until the next day when everyone looks at the idea again and decides that it wasn’t so clever after all.” The usual market contrarians move to the sidelines and those positioned on the wrong side during a coherent session add fuel to the fire as they rush to correct their inappropriate positions. When average opinion realizes that average opinion is becoming increasingly uniform and coherent (e.g. a “bandwagon” is starting) it very soon becomes entirely coherent. Entirely coherent markets lose their liquidity, at least for the duration of the session in question. Liquidity could thus be said to go through “phase transitions” as opinions among market participants move along a spectrum of fractiousness→coherence.
Read More : Intrepretation Of Coherent Closing Bias Of Trend Days
