Thursday, February 04, 2010

The Salience Principle

Here is a little nugget of trading wisdom: the market systematically punishes salience. Show me a strategy that makes use of highly salient information (i.e., information that is likely to stick in the mind at first, casual exposure) and I'll show you a strategy that underperforms.

Many mechanical/algorithmic programs make use of this principle, particularly at short time frames.

Going back to 2002, if you bought the S&P 500 Index (SPY) following an up day during an up week, the next week averaged a price loss of -.18% (338 up, 324 down). If you bought the S&P 500 Index following a down day during a down week, the next week averaged a price gain of .33% (283 up, 201 down).

Market technician Joe Granville famously asserted that if it's obvious, it's obviously wrong.

That's the salience principle, and it's why impulsive trades so often are losers.

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