How Hedge Funds (Ab)use Human Psychology to Increase Profits

I am a professional trader. That means that I buy and sell stocks for a living. And since I am a so-called ‘day trader’, the buying and selling have to happen within one day. This means that I am extremely short term focused: I try to anticipate where a stock will be at within five minutes or an hour from now, instead of five years.

As a trader, you obviously want to buy a stock as cheaply as possible, and to sell it for as much as possible. But if you think that studying financial documents and finding out what companies appear undervalued will help you in trading, you are only very partially right. Much more important, I dare to say, is understanding and using human psychology. And when you zoom in from years to days to minutes to seconds, the more important human psychology becomes.

Let me give you an example of how big hedge funds (which I certainly do not belong to) seem to use human psychology to increase their profits. I say ‘seem’, because I cannot prove this. If only because I don’t know who is buying or selling at any moment in time (but I can see what hedge funds own what stocks, and when they bought/sold). But given my everyday experience with movements in price, and applying common sense, I am reasonably certain.

Suppose there is a stock trading a little above $3. Last time it went to $3, it recovered to $10 within three years, and to $55 within six. Last year the stock was priced at $10, and ten years ago it was priced at $55. Therefore it looks cheap (irrespective of the fundamentals of the company). Hedge funds assume that many people are willing to buy at this price. Assume that many people do. Now hedge funds, with practically unlimited financial resources, come in. They create a level of resistance in the price. They do so by offering a practically infinite amount of stocks at best offer (being the lowest price at which people are willing to sell the stock: $3,21 in Table 1). By doing this, they create an upper limit in the price, since before the price can increase, all the stocks at best offer have to be bought, which is practically impossible given that the hedge funds have so much selling power compared to the rest.


Table 1: order book of stock


Now, since the price cannot go up, it will go down at a certain point. Be it because of algorithms trying to maintain certain correlations with indices, or because the hedge funds actively sell stocks at successive levels of best bid (the highest price at which people are willing to buy the stock: 3,19, 3,18 etc. in Table 1). Through doing this, the price will decrease to let’s say $3: a ‘psychological level’ in the stock. Many of the people who bought the stock thought it would never go under $3. Now people get anxious. Then the hedge funds give the final blow, and push through the $3. Now people start to panic – “maybe the stock will go to $2!”. They start selling the stock ‘at market’, meaning regardless of the price.


Figure 1: Arcelor Mittal stock


Now the hedge funds can buy the stock for less than $3 from the people who are selling at market, either to go ‘long’ (to have stocks), or to cover their shorts. See Figure 1 for a graphical display of this chain of events. Combine this with the fact that high frequency traders (acting on behalf of hedge funds) can change the order book in less than the blink of an eye (thereby changing the quantities on bid and offer), they can very quickly change the price of a stock. The price of a stock is after all nothing more than the price paid for the stock in the last transaction: so if you very quickly pull away successive levels of best bid, the next person selling at market will do so at a (much) lower price, meaning that the hedge funds buy at a lower price than the general public.

Now the hedge funds have bought their stocks, they pull back, and let the market do the rest.


An Application of Freud’s Theory of Mind

Everyone must have heard of the name ‘Sigmund Freud‘ at some point in their lives. Thinking about the name, there might be all kinds of images popping up in your mind: things like the mind being like an iceberg, notions like ‘The Id’ and ‘The Ego’, and Freud’s ideas about sex as the explanation for pretty much everything we do. But you might not fully remember all of it. You could say that the ideas might be floating around somewhere between your consciousness and your unconsciousness – to speak in Freudian terminology. But what was it exactly that Freud claimed? And why do many philosophers of science condemn his theories to the realm of ‘pseudo-science’? And what’s the value of Freud’s ideas? Let’s apply Freud’s ideas to an everyday situation and find it for ourselves.

Let’s imagine that you are a guy that goes out with some friends. You guys are ‘chilling in the club’, while suddenly an absolutely gorgeous woman enters the room. You notice a certain feeling taking control over your body: attraction, the feeling of you wanting – in whatever sense defined – that woman. This is not a feeling for which you might necessarily have arguments. No, the feeling is just there. This feeling comes down from the part of your personality that Freud calls ‘The Id. The only thing that The Id cares about is receiving pleasure, loads of it. It has an inextinguishable urge to grab on to everything within its reach, just for it to calm down its perpetual longing for pleasure; no matter how briefly the satisfaction might last.

You can imagine that society would be a rather chaotic institution if every one of us would just give into his animalistic urges at all times. The notion of rape would become little different from our custom of shacking hands. Therefore some basic rules of conduct need to be ingrained in each member of society: ‘Be gentle to others,’ ‘Help an old lady cross the street’ and ‘Don’t have sex with someone else unless that someone wants to’. It is within this domain of ‘The Superego‘ that all kinds of religious and political beliefs nestle. Beliefs that will guide you in living your life like a caged monkey.

Surely: it’s all nice that we are trying to control our animalistic urges by coming up with a set of reasonable rules. But who makes sure that the needs of The Id and the rules of The Superego are properly matched? After all, as we have just seen, they might contradict each other. So we can’t always satisfy both at the same time: we can’t just rape everyone and be a gentleman at the same time. And that’s where ‘The Ego comes in. The Ego is the controlling power, the power that tries to satisfy the needs of The Id while taking account of the rules of The Superego. The Ego is the house of reason, of the economically thinking part of you; the part that decides to fulfill the most pressing urges first – like the urge to still our hunger – and postpone not so pressing urges – like the urge to have sex – to a point in time at which satisfying this urge might be more ‘appropriate’.

Now you can understand why Freud sees our sexual drives as the prime reason for all our psychological problems, right? After all, it isn’t easy to suppress our animalistic needs, put forward by The Id. That can only be done by repressing the beast that lives inside of us. Or, to put it more boldly, the beast that we simply are. But taming the beast does not make it fall asleep. The beast is still there, waiting for his opportunity to come. And when it comes, he unleashes his true nature. So we have to do everything within our power to shackle the beast, everything in order for us to live a ‘reasonable’ life.

There are – and have been – many criticisms about the scientific status of Freud’s ideas, and you might see why. It’s after all quite difficult to capture something as intangible as ‘The Id in terms of empirical data. Nonetheless, Freud’s ideas have found to be very influential within the domain of psychiatry, even though the current generation of psychology students hardly learns anything about them.

Ah well, scientific or not, it’s still a pretty fascinating point of view, right? Oh, and for the guy at the bar: he took the girl home.

But what do you think?