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March 31, 2014 at 08:00 PM
It is no secret that humans are prone to overreaction. Take, for example, former Indiana University basketball coach Bob Knight throwing a chair in front of a player shooting free throws, or NFL coach Jim Mora ranting about the irrelevance of the playoffs after his Indianapolis Colts turned it over five times against the San Francisco 49ers, or a nation of Chicago Cubs fans forcing one of their own to contemplate joining a witness protection program after disrupting a foul ball. These are great examples of how humans can let their emotions blow a situation out of proportion.
Human overreaction is not limited to sports and is often a driver of volatility in financial markets. The abundance of financial data coupled with extremely low transaction costs has made it easy for investors to indulge in knee-jerk reactions to market events over the last decade. A negative news report can cause investors to heedlessly dump a stock one day only to see it chased back up to new highs the next day. For example, on Jan. 13, the S&P 500 (SPX) fell 1.26% as investors reacted to a Federal Reserve official hinting at additional tapering. However, the next day the index rebounded 1.08% on no material news. This whip-saw volatility can make life difficult for investors, but is a source of consistent opportunity for short-term countertrend traders.
The efficient market hypothesis has lulled people into believing that financial markets are completely efficient and that investors do not overreact to events in a predictable and exploitable manner. The statistics tell a different story. From the beginning of 2000 to the end of 2013, the S&P 500 was up 53.21% of its trading days. However, it was up 61.94% of trading days immediately following a day where the index was down by at least twice the standard deviation of its returns over the previous 20 days. Statistics suggest that there is only a 2.14% chance of randomly observing an up-day percentage as high as 61.94% over a 14-year period. Thus, these two-deviation-down days are likely instances of short-term overreactions that are quickly corrected by the market, and they present high-accuracy trading opportunities.
