Effects of an Underlying Irrational Mindset on Trading Crypto
“Truth is ever to be found in simplicity.”
— Isaac Newton
Mr. H. Sapien Esq. is a pattern recogniser. We see patterns everywhere. In our caveman days, we’d be aware of moments of sudden and unexpected quiet, tall grass shifting with the wind, and subtle changes of shade.
A change of light, a snap of a twig, and our pattern recognition software would trigger our fight or flight mechanism. Our sensitivity to pattern changes of light and vibration helped us survive.
The problem in the modern world is knowing when our inbuilt pattern recognition software is being manipulated.
The perfect example of an environment specifically designed to manipulate you is a 21st-century casino.
Flashing lights, noise, and distraction — even the carpets are “busy.” And of course, it’s all on purpose.
Most punters sitting at the slots are trying to beat the system, and if you do some research, it won’t take you long to find a snake oil salesmen offering secrets to beat the machine.
Let me save you the trouble. It’s mathematically impossible to beat a slot machine over time.
Yes, if you bet $10, hit the jackpot, and walk away, you can win. But over time you’ll lose.
Because casinos are factories. Think of casinos as a collection of mathematical algorithms designed to remove you from your cash. But not too fast.
It might start as entertainment. The allure of the big win combined with an environment engineered to hook you. A world that tantalises you with the fantasy of what could be, yet all the while slowly taking away your bankroll.
What have casinos got to do with buying and selling cryptocurrencies?
In Chariots of the Gods, we asked the question, “What separates the consistent winners from everyone else?”
The consistent winners, the five percent, profit consistently from the other ninety-five percent. They’re systematic and ruthless.
If you sit down in front of your computer, fund an account and begin trading in cryptocurrencies (or any other financial market) without an understanding of edge, position size and money management, the odds are high you are going to become a fully paid-up member of the 95% club.
You might as well take your seat at the slots in your local casino.
Perhaps you’re thinking, you’d never play the slots because it’s a mug's game.
Slot machines are noisy and distracting for a reason. They are a white noise mechanism designed to mess with your natural inbuilt biases. Just like a slot machine, the tools the 95% club use are intended to do the same thing. The trend now is for dark mode trading platforms that flash the “important” information in front of you.
Is this just for aesthetic appeal or for another reason?
If you start trading cryptocurrencies without an understanding of your biases, (and how they affect you), and without understanding your edge, you might as well be sitting in front of the video game reels pressing the bet button.
In fact, the reels you see on a slot machine are only for your entertainment. They don’t decide anything and are there entirely to mess with your biases. You lost (or won) the millisecond you hit the bet button. Running in the background, on all modern slot machines, and at all times, is a computer program called a random number generator, an RNG. The RNG generates a new random number thousands of times per second.
When you hit the button, everything that happens next is a symphony designed to keep you playing. Spinning reels, sound effects, and a light-show highlighting the payout table, all work together to manipulate you.
It works like this — the random number generator maps the current random number to a virtual reel. The virtual reel is preprogrammed with stops, and those stops have a predetermined chance of a win or loss and corresponding payout. The virtual reel is mapped to the reel you see and only after the result of your bet has been decided by the machine does the machine spin the “entertainment” reels to give you the result of your bet.
Because of your pattern recognising biases you start seeing patterns in the white noise. They are dragons in the clouds.
The slots use payout percentages to get your attention. If you see a machine with a 97% payout, do you understand how much you can expect to win if you play?
More people than you may realise, think a 97% payout means they’ll win 97% of their bet. (and get their bet back)
Others think 97% means they’ll win 97% of the time.
And some think it means 97% of the players will win.
Every spin is a random event, and casinos control how much money is paid out by adjusting the virtual reels and the pay-table.
This is called the payback. A slot machine with a 97% payout means the machine is expected to pay back 97% of all the cash put into it over the lifetime of the machine.
This is called the theoretical payback, but because slot machine spins are 100% random, the machine can go on a random walk away from its theoretical payback. Sometimes it can pay out more and sometimes less, and this is known as the actual percentage.
And it’s these patterns or walks that cause people to think they see a pattern. There is no pattern.
If you put $99 into a 97% payout machine and win nothing and someone else puts in $1 and wins $97, the slot machine is paying out its expected return.
You can lose all your stake money because each outcome is random.
Each time you hit the button on a slot machine, it’s an independent event. It’s 100% random. The game has no memory. It’s just like a game of spin-the-chamber Russian roulette.
If you don’t spin the chamber between pulls of the trigger the game of Russian roulette changes. With no spin between each pull, the odds of the gun firing are dependent on the previous pull of the trigger.
In Chariots of the Gods, we talked about the importance of building and understanding an edge. The game of blackjack works like no-spin Russian roulette. As each card is put in play, it affects the odds of the other cards being drawn. Each card drawn is a dependent and not an independent event.
The MIT blackjack team increased their bet size when the odds of drawing high-value cards, 10 through ACE, increased.
The team understood their edge. They knew, because of the way blackjack is played, the game has a memory. And because of this memory, the game becomes non-random at certain times during the game. And when the game entered a non-random state, the MIT team started betting big.
Their edge was small, but they made millions from it.
Random vs. Non-Random
The 250% emotion spike we feel when we lose versus when we win.
The instinct to pause and wait before you take action. This is because of your need for security and clarification from your tribe or peers. (Remember, inbuilt into you is the behaviour pattern of working together to bring down the hunt. Acting alone could have you cast out. If you rush in, you could get yourself injured or killed, and you could endanger your fellow hunters. So you wait.)
The fear of abandonment, the fear of missing out.
These biases are operating under the radar at all times. Occasionally, they manifest to a level that leaves tell-tale signs, a focal point in time, and if you know how to interpret the signs, they’ll give you an insight into the 95% club’s state of mind.
In academia, the big debate is — are the patterns on cryptocurrency (and all financial market) charts random or non-random?
Efficient Market Hypothesis
Textbook economic theory states that markets are random.
Let’s say you noticed that Bitcoin always goes up in August. For you to profit from your observation, you start buying Bitcoin in July. Efficient market hypothesis theory says that everyone else, who has noticed this, will do the same as you and your advantage will be cancelled out. To gain an advantage, traders will begin buying in June and, eventually, the effect of the trend will be dissipated. Its discovery will kill it.
Textbook financial theory, applicable to the cryptocurrency markets, assumes —
People are rational. They will make the obvious and rational choice at all times. They won’t pay too much for something they expect to go down in price, and they won’t ignore relevant information.
All investors are alike.
The price change is continuous.
Prices change due to the law of Brownian motion.
Let’s take each of these assumptions and ask a few questions.
People Behave Rationally
Is everyone rational at all times? Are you? Economics is a pseudo-science, in other words, it’s not a science but pretends to be. In 1776 Adam Smith, the Scottish philosopher and economist wrote a book titled “An Inquiry into the Nature and Causes of the Wealth of Nations.”
Smith’s masterpiece underwrites how the modern world works.
Economics is the study of how to arrive at the best compromise that makes the most people happy. In economic prose — The greatest wealth and happiness maximise utility.
This means that economic theory assumes investors are rational and they make rational decisions in financial markets in their own best interests.
Of course, if you ask someone if they behave rationally, they will almost certainly say yes, so instead of a pantomime performance of oh yes you are, oh no I’m not…
Let’s do this instead.
Show Not Tell
What choice would you make?
On the toss of a fair coin with exact 50/50 odds, receive $200 for heads and nothing for tails.
Skip the toss and collect$100 immediately.
What did you decide? Write down your answer.
Let’s alter the game.
On the toss of a fair coin with exact 50/50 odds, lose $200 for heads and nothing for tails.
Skip the toss and pay$100 immediately.
What did you decide? Write down your answer.
What decisions did you make?
In Game 1, the majority skip the toss and collect the $100 sure thing.
In Game 2, the majority take the bet because they want to avoid having to pay $100 with absolute certainty.
These two games are exactly the same in terms of return. A rational person would understand this, but when it comes to money and risk, we are not rational. We are irrational.
Because of the way we feel differently about taking a loss. Remember our biases? We experience a loss 250% more intensely than we experience a gain.
We see the games as different and the outcomes as different.
Expectancy shows us why.
Expectancy is one of the tools the 5% club uses against the 95%.
The formula for expectancy is simple, and it’s the starting point on your journey into the consistent winners club.
The formula is
(%Win x Average Win) - (%Loss x Average Loss)
Each of the two games above has precisely the same outcome no matter what you do?
Don’t believe me?…
Game 1: Flip a fair coin and win $200 if it lands on heads, or lose $0 if it lands on tails. Or skip the toss and collect $100.
Plug the numbers into the expectancy formula.
(50% $200) - (50% x 0) = $100
Or skip the toss and receive $100
The outcome is the same.
Game 2: Flip a fair coin and lose $200 if it lands on heads, or lose $0 if it lands on tails. Or skip the toss and payout $100.
(50% 0) - (50% $200) = -$100
Or skip the toss and payout -$100
The outcome is the same.
Cryptocurrency markets (and financial markets) are not robotically rational, because they are made up of people who are anything but rational when it comes to taking a loss.
Financial theory assumes you will always act in your best interest and behave rationally.
Now you’ve seen why. No telling required.
All Investors Are Alike
Financial theory assumes market participants have the same goals and the same time horizons, and given the same information, they’ll all make the same decisions. Textbook economic theory also assumes no one is powerful enough to influence price on their own.
People are not alike. If you buy bitcoin today and store it long-term in cold storage, you are different than someone who purchased bitcoin because of a technical signal on a chart and who plans to get out in the next eight hours.
Using two groups of stock investors, one group used fundamental information exclusively to buy and sell, and the other only used technical signals on charts to buy and sell, the interaction between the groups lead to price bubbles and crashes. Bubbles and crashes are the signatures of irrational, not rational behaviour.
The study used only two different groups of investors. In reality, the numbers of groups and motivations for each group is unknown.
Price Change is Continuous
In Puppet on a String, we talked about how price moves. It’s to do with the number of buyers on the bid and the number of sellers on the offer. It’s not the absolute number. It’s a ratio. Prices can and do, move between one level and another depending on this ratio. If there are no buyers on the bid at a certain price and a seller wants to sell, they have to drop their price down to meet the bid.
Modern finance theory assumes price movements are continuous and move smoothly from price to price.
2:32PM 6 May 2010: Prices in the Dow Jones Industrial averages collapsed, dropping nearly one thousand points in seconds. One trillion US dollars was wiped off the value of stocks. It became known as the Flash Crash. The crash lasted thirty-six minutes and debunks the continuous movement of price theory. If there’s no one on the bid and many on the offer who want (or need) to sell, look out below.
Prices Move in Brownian Motion
Brownian motion describes the random movement of particles suspended in a liquid that collide with faster moving molecules. The movements of the particles are distributed according to the normal or Gaussian distribution, aka the bell curve.
Financial theory assumes price change behaves just like particles suspended in a liquid and are also best described by using the bell curve. In other words, financial theory assumes price changes conform to the normal distribution.
Financial theory states prices move—
Independently. No matter if it’s a 5 tick up move or a $10 move, each move is independent of the last, and what happened in the past has zero influence on what happens in the future. It assumes looking at charts is as much use as reading tea leaves.
Price changes are statistically stationary. It assumes the process of generating price change stays constant over time.
It assumes price changes are random at 50/50 odds and nothing can ever happen to influence the odds at any point in time.
Financial market returns follow the normal distribution.
The distribution of human height conforms to the normal distribution. Our height distribution forms a shape with a tall bell in the middle that tapers off sharply at each end.
This shows that extremes are rare.
You don’t find many people under 3 feet tall, and you don’t find many who are over 8 feet tall either.
If you took the entire number of stock market returns and put them down on a scale, they do not form the same shape as human heights. The academic world says they do. Evidence says they don’t.
The shape financial market returns form has gaps at the edges between the shape and its base. Statisticians call this phenomenon Leptokurtosis.
You may have heard of its more common name.
If financial or cryptocurrency market returns followed the bell curve, there would hardly be any outliers in the returns. In the same way, you don’t find many 8 feet tall humans you shouldn’t see many outliers in stock returns.
Instead of trying to persuade you, I’ll show you.
This chart shows the daily returns of the Dow Jones Industrials since Jan 2, 1900. That’s one hundred and eighteen years of data.
The chart shows the log returns in terms of standard deviations away from the mean.
Do you notice the tall spike in 1987?
This spike, a move of over 22 standard deviations, has a 10^50 (10 to the power of 50) chance of happening.
Practically impossible. Yet it happened.
If the financial market returns followed the bell curve like Brownian motion, each spike would be uniformly around one on this scale and outliers would be under three standard deviations.
As you can see, the returns are wildly different. There’s no uniformity in the outliers. 1929, 1987 and 2008 crashes are all clear.
We don’t see people 6 inches tall, and we don’t see anyone 20 feet tall either.
Human heights are normally distributed. Financial market returns are not.
Where The Edge Lives
The MIT blackjack team were successful because they understood their edge. They understood blackjack has a memory because the cards drawn affected the likelihood of specific cards remaining in the deck. They realised at certain times during the game, the game shifts and became less random. Their system was designed to recognise the points in time when this happened, and when it did, they increased their bet size.
We’ve talked about pattern craving and how our biases can be used to our disadvantage. We’ve discussed slot machines because they represent a purely random process many people see as pattern producing, and we’ve discussed accepted financial theory because just like slot machines, financial markets, including cryptocurrency markets are supposed to be random.
In Shapeshifter we’ve seen they’re not.
Statistically, we see the evidence in the fat tails, and it’s where the edge lives.
Emotion bars and tests are the moments in time when cryptocurrency markets become less random, and we can use the footprints they leave behind as the signal to start building an edge.
Like the MIT blackjack team, if you can find times when cryptocurrency markets (or any financial market) becomes less random and if you can combine this with position size and money management, you'll be trading with the 5% club and not with the rest of the crowd.