Temporary Insanity and Market Psychology
INTENT AND INSANITY IN CRIMINAL LAW
Many years ago I attended law school for one year. Never really wanted to be lawyer, but had been told by many that first year law school was as good as an MBA for a person interested in pursuing a career in private business. So I opted for the first year law school approach, even though it provided no “sheepskin” to hang on the wall. After all, I am the sort who got a BS and put the sheepskin away in a drawer – and it is still there.
One of the courses in first year of law school was criminal law, which I really enjoyed. Reading the cases of various legal defenses was great fun. One of the most fascinating concepts in all of criminal law is the element of a crime that involves “intent”. The prosecutor must prove that the accused had the intent to commit the crime. Simply proving that the accused actually committed the crime was insufficient – there must be proof of intent. To most lay people, simply proving that a person did something is enough to convince them that a person is guilty. Intent is implied in such reasoning – and it is a hard concept to refute. Most normal people tend to think that doing something is adequate proof of intent to do so. But what about accidents – don’t we all do things from time to time that produce unintended results?
And then there are those that are crazy – or more properly insane. By our legal definition an insane person cannot intend to do something illegal. Insane people do not know the difference between right and wrong, so they are presumed to not have the ability to have intent as legally required in a criminal charge.
And then there is temporary insanity. The person is deemed to be sane before the act and sane after the act - but “insane” at the moment the criminal act was perpetuated. Of all the legal defenses I read about, this one fascinated me the most.
MARKETS MASS PSYCHOLOGY
But what does all this have to do with trading? Well, the markets we trade are moved by psychology – the mass psychology of all market participants. And from time to time, a market may display “temporary insanity”.
Many pundits will say that the market is always right – and I agree – in the long run. However in the short run a market can, and sometimes does, in my opinion, display a period of insanity. Sometimes these periods are very short term – lasting only minutes. But sometimes they can be much longer in duration – lasting days or weeks.
The trader must be very careful in assessing temporary insanity in the market being traded. First, is it temporary insanity? Secondly, what is the duration? Personally, I try to avoid trading the periods of temporary insanity that are of short duration. But, I do like to trade those of longer duration because when market regains its sanity there is usually a significant move in price – a correction for the period of insanity.
THE RISKS OF TRADING MARKET TEMPORARY INSANITY
After all my years of trading, I still have found no reliable technical means of predicting temporary insanity. As in legal cases, temporary insanity can only be proven after the fact – by definition it is temporary.
But temporary insanity can be assumed by the trader – we are not required to prove the insanity in order to make our trade based on our assumption that it is temporary - and that we think we know which way the market will move once the insanity ends.
Trading market temporary insanity is very risky – but the reward may justify the risk. Payoffs of ten times the risk – and sometimes even more - are not uncommon.
However, to judge whether a market is experiencing temporary insanity or not must made on the basis fundamentals. As technical traders we must understand the basic fundamentals that are driving the markets we trade. When the market psychology moves in a direction that is not supported by those fundamentals – particularly a significant move in a brief period of time - it may be a case of market temporary insanity. If it is a case of brief market insanity, it is probably best to stay out of the market until the psychology corrects itself.
However, when any market continues to defy the basic the fundamentals that normally drive that market for an extended time, the astute trader – technical or not – is alert to an impending opportunity to make a trade at or very near the point that the market begins to make its correction.
Now that was really easy to say – but it is a lot harder to perform. Lord Keynes said it best, “the market can stay irrational longer than you can remain liquid” (that is my recollection of his quote – not necessarily his exact words).
So what kind of examples can I offer in support of this case for market temporary insanity?
How about the USDJPY FOREX market, for example?
The Japanese government has announced a monetary policy that is virtually guaranteed to make the yen weaker – and substantially so – for the foreseeable future. I have read several credible sources saying that the yen is likely going to 200 to the dollar before the Japanese change their monetary policy.
Now the US dollar has its own problems and the yen versus the dollar may well be a ugly contest. But with the Japanese government’s current policies it would seem that the Yen is going to come out uglier.
Figure 1 USDJPY Daily – 1-27-2014
Look at the chart in Figure 1. Starting last October the yen has lost ground relentlessly to the dollar as the Japanese government begins its debasement of the yen. Today, however, the yen has regained more than big points – from above 105 to below 102 - against the dollar in less than three weeks. And all the while the Japanese have re-iterated their intent to proceed to debase the yen.
Could this be a case of temporary market insanity? I cannot categorically state that to be the case. But I ask myself several key questions:
1. Why the sudden reversal? My answer. Nervous market – yen traditional safe haven.
2. Is “why” rational? I doubt it – dollar no paragon of value, but yen looks even worse down the road.
3. Assuming its temporary insanity - when will the insanity end? I do not know, but I am watching for technical trading signals pointing to opportunities to go long this market and hope to be in such a trade when the insanity (if it is) finally ends.
Obviously, the key to this trading approach is to keep the risk of my trades low. Possibly lose a little now and then, but also make a little profit here and there – with the goal of being long when the larger move comes along. As a technical trader I see no harm to having a pre-disposition to trade in a given direction. I consider that a safe way to combine technical and fundamental decision making when trading.