Oil Traders Find A Profit In 'Voodoo' Science

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Oil traders

Out of the frenzy at the New York Mercantile Exchange, a price for oil emerges. Mario Tama/Getty Images hide caption

itoggle caption Mario Tama/Getty Images

The Economy Explained

Your questions answered on:

Economists use lots of fancy math to try to understand the economy. The problem is that their equations don't always take into account the millions of real people making decisions small and large.

Take the practice of trading oil. Every work day, traders in the oil pit at the New York Mercantile Exchange crowd around in brightly colored vests and yell out orders to buy and sell barrels of crude. Out of their frenzy emerges one of the miracles of the free market: a price.

I expected the traders I met here to be experts in oil shipping schedules and the politics of distant places like Saudi Arabia and Azerbaijan. But trader after trader told me that while they do watch the news, they have easier ways of predicting the markets. They print out the charts of where the market has been — the peaks and valleys. Then they draw lines off into the future.

They use history to forecast what comes next. "I actually use a protractor," says Randall Rothenberg, who trades natural gas. Rothenberg explains that he draws what are known as Gann angles, after the mathematician who designed them. From those angles come the charts that inform his trading strategy.

Rothenberg says prices sometimes move as if propelled by magic. Traders encounter what they call support or resistance levels, which function as ceilings or floors. The price of crude oil approaches that magic number, but then turns back.

The Science Of Magic

Charting prices and trading on perceived patterns has a name — technical analysis. It has scores of variations. People have written books about it and computer programs to help with the analysis.

According to textbook economics, technical analysis should not work. Markets are supposed to be driven by the cold logic of supply and demand. If a hurricane is heading for the Texas refineries, the price of oil will go up because people fear a shortage. In a recession, the price of oil drops, because fewer people will be driving.

Technical analysis has been compared to astrology and to reading the entrails of a goat. Traders say they've heard the naysaying, but they're sticking with their system. They say they don't know why it works, but it does.

"There is something to these numbers," says trader Anthony Grisanti, the president of GRZ Energy. "When a market gets to a number three or four times and reacts off that number, then it's a big number. So yeah, I don't think there is any analyst or anybody in the industry that would say just disregard the numbers."

Faith like that got Carol Osler interested in learning more. She's a professor of finance at Brandeis University. "To economists who are used to thinking in market forces and grand theories, the notion that a sequence of lumps and bumps is going to predict a price is completely ridiculous," she says. "They think it's just like voodoo, and I mean, I came at it with that impression initially."

In the late 1990s, Osler and a colleague studied the currency markets — where people trade the dollar, yen, the mark. She says technical trading was popular among currency traders all over the world.

Osler was intrigued with one configuration — a series of three bumps. "I decided to start with the 'head and shoulders' pattern, which seemed the most voodoo-ish," she says. Traders take it for an omen that prices will drop.

Osler and her colleague analyzed data going back to the 1970s. Much to her embarrassment, she discovered that the pattern was indeed right about where the market was pointing — or at least that it was right often enough for traders to make money using it.

Profits to traders mindful of the "head and shoulders" effect would have averaged 10 percent to 20 percent a year, better than returns from the stock market. Osler says she still has no idea why this stuff works.

"When I first started looking into this, I read eight different technical analysis textbooks," she says. "I was fascinated to look at the way the people who wrote them tried to justify this stuff. They used metaphors — one of them was armies. You know, they're slogging up the hill! And then the people at the top fight them back down. Another was trains. It's just metaphors!"

The Human Effect

One theory about technical trading is that these patterns exist because people will them to be there. If people think the market will drop after a "head and shoulders" series of bumps, then those people will sell now to avoid lower prices later. Their selling causes the market to drop.

"Over time, these kinds of patterns ended up becoming almost self-fulfilling prophesies," says Andrew Lo, a professor of finance at MIT and author of A Non-Random Walk Down Wall Street. He says he sees human psychology very much at work in the history of market of prices. "I view that as a very rich fossil record of the different kinds of individuals that have engaged in these kinds of market dynamics."

Here's another metaphor: If you think of the market like a river, then the overall flow may be governed by supply and demand. But some of the little eddies might be governed by merely by weird human behavior.

In recent days, as the price of oil plunged over a waterfall, I called trader Randall Rothenberg back, to see how technical analysis had served him. He said he'd made money.



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