Wheat Market Illustrates Behavioral Patterns
Troy Buckner, founder of NuWave, sheds light on the connection between recent
experience in the grains market and behavioral finance. He argues that managed
futures models can benefit from a greater recognition of psychological factors.
For a profile of Mr. Buckner, see our April 8th issue. NuWave currently manages
around $800 million.
"Very significant moves get corrected almost 100% of the time, even if the
overall drift in a time series continues."
After Russia announced its ban on grain exports, wheat prices rose to peaks not
seen in two years. Yet economic fundamentals had only changed on the margin and
expectations of supply and demand were not dramatically altered. The price
nearly doubled in a few weeks, but supply will be down maybe 6% to 7% from the
previously expected level.
This is a dramatic example demonstrating that fundamentals alone do not explain
market moves. We have to look to behavioral finance theory to understand what's
Individuals reacting to information drive prices. Ultimately, human emotion is
responsible for repetitive scenarios in the marketplace. The key emotions are
pretty much summarized by a short list: fear, greed euphoria and despair. It
does not so much matter what the catalyst is, these emotions cause repetitive
patterns that can be seen in basic scenarios.
Why would anyone buy wheat at over $8 a bushel when it was around $4 just a few
weeks back? A casual observer would probably argue that the commodity is not
fairly valued at the high price. But suppose you are afraid of losing your job
if you don't have enough wheat to manufacture your product, or maybe worse, that
you can't feed your population. Then fear takes over and makes you do something
that is contrary to the fundamentals in the marketplace.
From the outside perspective it may seem like market participants are
irrational, but your decision to buy at the extremely high price is not
irrational to you. After all, you're petrified that you might lose your
livelihood! Several months from now, we can look back and decide that the
response was overly emotional. But in early August, it seemed to dominate the
Various factors create price moves that would not be predicted on rational
grounds. Here is another example. Last year a farmer had to sell his wheat at a
very low price. Another year like that and he might not be able to stay in
business. He was desperate to get at least a reasonable price. Early this year
this farmer had information suggesting prices should be substantially higher. If
he held out, he would get more value.
And yet his personal situation and emotions made make him accept the current price,
counter to what he believed will likely happen in the market. He had to hedge
his bet and could not wait for a higher price.
Gaining an Edge
Human beings change very little over time. That is why there are repetitive
patterns in time series. The environment changes and many factors are in
constant flux, but the human emotional makeup is essentially constant.
You might reply that we all know there are emotional factors at play in markets.
That may be, but there is a significant amount of contextual information that is
ignored by many strategies. A systematic trader might trade simply on a
breakout, but that movement is only a small piece of a bigger picture. There is
more information in time series.
In modeling time series of prices, we can identify similarities and differences
between today's scenarios and historical scenarios. Knowing the previous
scenarios, you understand better the current time series movements. A given move
in a time series should not be viewed in isolation but relative to other
scenarios that are similar or different.
What are the previous moves that this might be best compared to? To put the
current price action into context, we need to know the precedents. That way, we
can get an idea of the big picture that reflects the reactions of the human
beings who drive the market.
At NuWave we analyze time series for clues as to what's behind the price moves
and whether they will persist. How probable is the continuation of the price
based on the patterns discernible in the time series? Ultimately we want to know
whether there is high enough probability for the price to persist in a given
direction in order to warrant risking capital.
It is not enough from a risk/reward standpoint to simply buy the momentum as it
goes higher or sell the momentum as it goes lower. If you understand what's
behind the reaction and the odds for the price to persist or change, then you
have an edge.
In the markets we trade there are hardly any examples of dramatic moves that do
not correct. Very significant moves get corrected almost 100% of the time, even
if the overall drift in a time series continues. With wheat, our models suggest
that the more likely possibility is a downward correction.
You have the question of whether to participate on the long-term trend while
dramatic short term corrections may be going on. Such corrections can take
several months. At NuWave we may see these situations as an opportunity to be
tactically short even if we forecast an upward long-term trend.
The impact of emotions is not the same across markets. I believe equity markets
are typically more efficient than commodity markets, because there are so many
different types of participants in equities with a great deal of information.
While there are still emotional responses, equity markets are relatively
By comparison, in commodity markets there are fewer players and therefore more
potential for volatility. Further, the near-term risk associated with
underestimating something like the food supply is arguably different than the
risk of underestimating GDP. That's why dramatic price moves in a short period
are far more common in commodities than in stocks. A few days' move of 10% or
15% is extraordinary in equities but commonplace in commodities.
To exploit market inefficiencies, NuWave's strategies are designed to study time
series data in order to understand moves that are rational in the context of
history and those that seem irrational. Either scenario offers opportunity.