Pattern Recognition: Works in Trading and in VC

This is an interesting clip by Professor Steve Blank from Stanford.  He is talking about entrepreneurs and venture capitalists, but he easily could be talking about trading.  Pattern recognition keeps technical analyst traders in business.

One skill that successful floor traders were extremely keen with was pattern recognition.   Seeing something happen and taking advantage of it-then knowing when the pattern broke.  I remember trading Eurodollars ($GE_F) in the late 80’s and for a while, every time the Japanese Yen ($JY_F) moved one way, the Eurodollars would move the other way.  Few saw the pattern and so it was easy to create an edge for yourself.

I recall another time I saw all these things line up at once.  No one else saw it.  I started buying everything I could in the market.  I turned to spread some of my position off and another trader grabbed me by the back of my neck and screamed, “Sold”.  I turned and said, “Buy 1000″. By the time we could card them up the market was moving higher in a hurry.  The blood drained out of his face.  I made money.

When the pattern broke down, lots of people lost money.  It’s key to know when the underlying market is changing.  I think that electronic trading makes it a lot more difficult for humans to recognize patterns and take advantage of them.

I think this is why you are hearing so much talk about tech bubbles and other bubbles today.  People are seeing similar repeats of patterns they saw before.  It’s awfully hard to predict which company is going to be the next billion dollar company.  It’s also awfully hard to predict which company will go bust that currently is a billion dollar company without inside information.

The other thing to remember about pattern recognition is that the big money is made when you are first to recognize a new pattern. Not only do you have to recognize it, but you have to have the courage to take advantage of it.  Usually a when a new paradigm emerges, there are no hard and fast definitive data points that will tell you the move is right.  That’s where gut feel comes in.   It’s also where Chance IV comes in.  Successful traders were really good at putting disparate pieces of a puzzle together to create something new.

New patterns also invite ridicule.  Your friends will tell you that you are insane.  People will tell you that you are wrong.  That’s why you have to be comfortable being away from the herd.

In trading, feedback was received in a relatively short period of time.  The investment is also liquid.  You can get out if are wrong-although there is a charge for it!  Liquidity has a price.  In venture capital investing, the feedback period can be years.  There is no “Get Out of Jail” card for a loser.  As we used to say in the pit, “You’re wearing them”.