It seems like I saw a thousand tweets this week about this paper, published in the Proceedings of the National Academy of Sciences of the United States of America. The general sense was that the article supported trend following, specifically trend following for day traders, as a profitable trading strategy, but after reading the paper, I came away with a different interpretation.

First of all, one of the primary points of the paper was to study day traders’ use of instant messaging and information exchange in making their trading decisions, a point which was totally lost in the US News and World Report article that seems to have become the financial blogging community’s primary source for this research. The study looked at instant messaging rates between traders at a single day trading firm, and concluded that the traders were messaging and trading in bursts. Furthermore, traders were most profitable when they acted together, but they were trading at a rate that could not be explained by their instant message traffic.

I read a lot of academic research, which is a little unusual for a trader. The vast majority of papers published never make it into the public focus, but I have noticed a pattern with the ones that do: a journalist writes an article about a scientific paper, and another expert is quoted (Albert-László Barabási, in this case) in a way that supports the journalist’s slant on the article, which may or may not be the actual focus of the research. Perhaps that expert is quoted out of context completely (yes, it happens), or perhaps the focus is only slightly off-center from the original research, but the end result is that everyone who only reads the journalist’s article misses the point of the original research. In this case, thousands of people have seen links to this research on Twitter and now have mental pegs that say “an academic paper was published that says trend following is a good strategy for daytraders”. This is unfortunate because it is not true. What the article actually says is that traders at one firm were more profitable when they placed trades at the same time. What if the firm was a group of traders who specialized in counter-trend fading strategies? My point here is this: don’t reduce academic research to a sound bite, be suspicious of any reference from any source that does so, and read the research yourself.

From the abstract: “Analyzing empirical data on day traders’ second-to-second trading and instant messaging, we find that the higher the traders’ synchronous trading is, the less likely they are to lose money at the end of the day. We also find that the daily instant messaging patterns of traders are closely associated with their level of synchronous trading. This result suggests that synchronicity and vanguard technology may help traders cope with risky decisions in complex systems and may furnish unique prospects for achieving collective and individual goals.” What this suggests to me is that they analyzed a group of traders who had developed a strategy and traded it together. The synchronicity they observed is probably due to traders applying the same strategies and styles of trading during the day, which is not surprising at an individual firm. The importance of IM traffic could be traders pointing out stocks that were setting up for potential trades, then the traders turned from IM to their trading platforms and executed their strategies more or less in tandem, which is what you would expect from a group of traders trading in a similar style.

One last thought. If papers and research like this interest you, it’s usually not too hard to track down contact information for the authors of published research. Like anything else, your mileage will vary, but I have found many of them to be very interested and responsive to questions from people reading their research and trying to understand how it applies in the real world. If something catches your attention, write an email. Think hard about it first, have focused and insightful questions, but never be afraid to say “I don’t understand…” You’ll be surprised what you can learn that way. (And, above all, avoid the sound bite!)

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Update 3/30/11:  The author of this paper left a comment on the blog that I felt offered some new information and a valuable perspective.  I have moved this comment into the body of the post.  Thank you, Serguei, for the additional insights.

Dear Adam,

I am Serguei Saavedra, the leading author of this paper. I came across your blog and found this very clever post of yours. You are completely right, some times journalists can give a very wrong impression about research findings, and this was not the exception. As you can tell by reading the paper, what we found was that the simultaneous trading activity of different traders (note that stocks can be different and one can also have a mix of buying and selling activities) can signal the right time to act in the market. However, this simultaneous activity that we call synchronous trading is measured relative to what would be expected simply by chance (so one could argue that if one keeps trading every single second, eventually one could synchronize with all the rest. However, once you control for the number of trades, this observed synchronicity is similar to the one expected by chance, and therefore, this trader’s synchronous trading would be close to zero) and has to occur within very short intervals. Hence, herding is not an option. Imagine one is lining-up in the supermarket and suddenly a new till opens. Few people are going to simultaneously recognize the opportunity and move quickly to the new till, perhaps because they actually saw that the cashier was calling them or simply because they imitated the people surrounding them. However, if one does not move quickly to the new till, and after a while reacts as a herd and moves, one is not going to take any advantage of that movement (since probably the new line is already crowded). Only the people who reacted simultaneously and within a short interval are going to receive the benefits. Well, this is similar to what we found. Traders that are able to recognize the right time to act simultaneously with others are the ones that receive the benefits. In fact, we found no correlation between performance and acting late or ahead the crowd. However, different from my bold supermarket example, individual traders do not know when is the right time to move (they can only make inferences); only by using these sort of data, one can look for these collective patterns and recognize when others are moving to the new till. Nevertheless, the mechanism helping traders to recognize or sync to the “pulse of the market” is information. This can arrive across different channels; obviously, we cannot know all the information traders are looking at at every single second. Interestingly, we can use IMs as a proxy for that information. Importantly, we found that the more different from random a trader’s IMing patterns are, the higher the probability that the trader can sync with other traders. This suggests that once a trader starts using IMing as a source of information and corroboration (and not just a random distraction), the higher the trader’s chances of being in rhythm with the market. I am very glad that you got the right story of the paper!

Serguei