Given people’s sensitivity to rising prices, a minor series of price increases can trigger the perceptions that cause bubbles. Still greater sensitivity to falling prices can allow a single price drop to prompt a follow-on crash. Market manipulation triggers many price bubbles by artificially creating a series of price rises that attracts new buyers; the new buyers let the manipulators liquidate their position at a profit. Manipulators can also trigger price crashes by undermining prices with short sales, scaring existing stockholders into selling cheap so the manipulators can cover their positions at a profit. Some say that last fall’s peso collapse was engineered by manipulators who shorted the peso and bought dollars, then covered their positions when scared peso holders vied desperately to buy hard currency before it became unaffordable.

Not all bubbles and crashes stem from intentional market manipulation, but frequent attempts at manipulative strategies, as well as prohibitions against manipulation in various countries, do confirm people’s sensitivity to price trends. Rather, many bubbles and crashes occur in response to price trends initiated by fundamental news or a random run of liquidity-based purchases or sales. The triggering event attracts new buyers or new sellers on the lookout for incipient trends, they take their positions, and the overshooting begins.

Once a bubble (or crash) begins, it takes on a life of its own. The trend attracts new buyers (or sellers) who extend it, which makes it a compelling opportunity to still more new buyers (or sellers). At the same time, people actively guage the odds that the trend will end and reverse, looking for the right opportunity to sell (or buy) the by-now overpriced (or underpriced) security. The ones guaging the odds may be the same buyers (or sellers) actively bidding up (or offering down) the security, recognizing that the opportunity for quick gains also contains the seeds of a sudden reversal. Given this interplay of bulls and bears, bubbles and crashes never follow a straight line; instead, they constantly fluctuate, but with a clear bias in one direction or the other.

Traders may quickly lose interest in a one-security bubble, or they may extend it for several months. A one-security bubble may create a contagion that spreads to similar securities: an initial bubble in the Spain Fund prompted traders to begin speculating in other closed-end country funds, leading that sector to boom, complete with a hot initial public offerings (IPO) market that increased the fund population from fourteen to forty- one in less than a year from the initial stirrings in the Spain Fund. This sectorial boom fizzled out as so many do, leaving behind a lot of underperforming IPOs and burned speculators, but occasionally sectorial booms may join up so that a whole market booms, as Mexico’s did in 1987.

Identifying the bias in a bubble or crash is the province of technical analysis. Any decent technical analyst can accurately describe the prevailing bias for a security, a sector, or an entire market. However, adequate technical analysis alone is not enough to create the kind of profitable trading strategies that could convince market regulators to change the rules to reduce the incidence of bubbles and crashes. That’s because a very significant proportion of bubbles and crashes end with very substantial reversals. Thus, a naive portfolio can make significant profits most days by holding bubbling securities (or selling short crashing securities, or hedging market risk by buying bubbles and selling crashes), but will frequently lose its accumulated profits and more in those infrequent but very large reversals. Some technical methods eke out a minor profit, but very few capture a significant proportion of the profits available from buying bubbles and selling crashes. That is the province of expert traders.

Expert traders capture many of the very short-term price movements in a bubble or crash. By capturing many short-term movements, the expert trader takes advantage of the constant fluctuations that characterize bubbles and crashes. Rathering than just capturing the average of all those movements, the expert captures the sum of all those movements; a substantially greater profit. The expert trader may occasionally suffer the reversal at the end of a trend, but by capturing more profitable price fluctuations and by avoiding losses on many reversals and limiting losses on reversals when avoidance wasn’t possible, the expert trader can profit substantially from the opportunities that bubbles and crashes present. This research project into bubbles and crashes includes the identification of expert traders, both robotic and human. The next column will describe more of this effort.

Readers with questions or comments for Dr. White can call 011(525)595-6045, fax 011(525)683-5874, or email white@profmexis.sar.net

Return to Mark White's Home Page

This page hosted by Get your own Free Home Page