Written by Michael Bigger. Follow me on Twitter.
Seth Godin wrote a fabulous blog post about a cool mathematical concept called the Levy flight that shows up in nature (Wikipedia: Levy Flight Description).
It also shows up in finance.
A journalist finds an interesting story to write about. Think about Merck and Vioxx. That was big business
news, and it stirred up emotions. Many people took a stance on both side of the issues related to this event. Writing about Vioxx generated good readership and sold advertising. Eventually, readers got bored with the story and moved on. Our journalist had to find other news. The journalist’s path follows a Levy flight from one random walk to a cluster followed by the same process over and over again, as depicted in the image (Source: Wikipedia).
Or you can think about it this way: the path between each cluster is a stochastic directional vector and the cluster is a manifestation of the cockroach theory. This theory states that if you find a roach in the cupboard, more than one is usually crawling in the same location. Using Godin’s example, once an animal finds food along its random walk, the animal will rummage in the same area because the likelihood of finding more food is elevated.
For traders, investors and algorithmic traders, a few things are of interest here:
- What is the relationship between a cluster and volatility?
- As journalists migrate from one story to the next, is tension being released on the system? Is that a form of catalyst (value trading and volatility trading)?
- What are the roles of traders or investors in these situations? Do they also become news amplifiers within the cluster? Do they contribute to the catalyst after the cluster disintegrates?
- When a news cluster starts forming, could monitoring social media, finance groups, or other venues help predict entry into a cluster or an exit from it?
- If so, could we use Internet message analysis to incorporate jump function into a Brownian process?
- If the cockroach theory is such an important part of behavior, do market participants under appreciate it?
- If so, how do we exploit it?
The Levy flight is worthy of further analysis. I can see a few ways to incorporate this concept into our algorithms right now.
When the next “Vioxx” crisis erupts, I will remember that journalists will eventually walk away and let it go. The news will subside as it always does. Benjamin Graham once said this: “This too shall pass.”
Since I wrote the original post, we’ve used this mental model to sell volatility on Goldman Sachs when the fraud scandal erupted in April 2010. You can read more about it here: Levy Flight, Truffle Diggers, and Goldman Sachs. The trade was highly profitable, and we unwound this trade in early July after the truffle diggers got bored and moved on to another story. The Gulf of Mexico became a much more powerful story to cover.
Recommended reading: Linchpin: Are You Indispensable? by Seth Godin (Amazon Affiliate Link).
Let me know what you think.