A New Look at Clustering of Stock Prices

Author(s): Victor Niederhoffer

Source: The Journal of Business, Vol. 39, No. 2 (Apr., 1966), pp. 309-313
Published by: The University of Chicago Press
Stable URL: http://www.jstor.org/stable/2351480
Accessed: 19-03-2015 17:28 UTC

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 A NEW LOOK AT CLUSTERING OF STOCK PRICES*
VICTOR NIEDERHOFFERt
T HE psychology of numbersis a fas-
cinating subject which should re-
ceive more attention from stock
marketanalysts. Until recentlytherewas
little systematic research in the field.
Leads can be gathered from the work in-
other disciplines.Motivational research-
ers have convincedmerchandisersthat a
sales price of $2.99 is a far more attrac-
tive figure for the purchaserthan one of
$3.00. It is common knowledge among
policy bookies that thousandsof players
will flock to place their bets on the same
number at the occurrenceof some un-
usual symbolic event.
The literatureof the stock marketcon-
tains similar illustrations: from Gann
writing in 1930,1who found that "The
populartrading prices are 25, 40, 50, 60,
75, 100, ... ."; to Wyckoff in 1963,2 who
declaredthat "We think in round num-
bers and try to sell at round numbers."
The violent, short-runmovements of
the stock marketaveragesare frequently
ascribedto heavy publicbuying or selling
as the average moves through certain
round numbers. However, the sophisti-
* The author wishes to express his gratitude to
Professors James Lorie and Nathan Keyfitz of the
University of Chicago and Arthur Niederhoffer of
Hofstra University for their helpful suggestions.
Financial support for this study was provided by the
Center for Research in Security Prices, University of
Chicago.
t Graduate School of Business, University of
Chicago.
1 W. D. Gann, Truth of the Stock Tape (New
York: Financial Guardian Publishing Co., 1930),
pp. 63-64.
2 Peter Wyckoff, The Psychology of Stock Market
Timing (Englewood Cliffs, N.J.: Prentice-Hall, Inc.,
1963), pp. 106-7.
309
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cated analyst would do well to study the
effect of investor psychology upon price
movementsin stable situations as well as
in times of bandwagonbuying or stam-
pede selling.
Such an approachis particularlyrele-
vant to an understandingof the contro-
versy surroundingthe theory that stock
market prices ending in even eighths
occur far more frequently than prices
endingin odd eighths.The evidenceseems
to show that this peculiar phenomenon
depends to a large degree on the predi-
lection of investors to place orders at
roundnumbers.Almost all marketorders
are matched with limit orders. Hence,
the record of transaction prices follows
closely the record of limit orders. But
some 84 per cent of limit orders on the
books of specialists are typically at even
eighths.' Therefore, we might naively
expect a certain amount of clusteringat
round numbers, which are, of course,
numbers ending in an even number of
eighths.
Osborneappearsto have been the first
one to test this rigorously.4He sampled
the closingpricesof stocks in which there
were sales of more than fifty round lots
in a week. Of all closing prices, 60.8 per
cent were at even eighths. Hence, we
christen this tendency for even eighths
to appear more frequently than odd
eighths the "Osborne Effect." Further
confirmationof the Osborne Effect was
3V. Niederhoffer. "Clustering of Stock Prices,"
Operations Research, XIII (1965), 258-65.
4 M. F. M. Osborne, "Periodic Structure in the
Brownian Motion of Stock Prices," Operations Re-
search, X (1962), 345-79.
310 THE JOURNALOF BUSINESS
obtained by the present author whose eighth removed from the previous
data included the closing prices of five transaction.
Stratum 3. All transactions at a price one-quar-
consecutive samples of two hundred ter or more removed from the previ-
stocks whose prices remainedunchanged ous transactions.
for the day and were selling at a price
below 50. The proportionof all closes at For example, the prices of the first
the even eighths was .66.1 eight transactions in American Airlines
Godfrey and his co-workers6also at- on November 13, 1964,were respectively,
tempted to test the frequenciesof even 451, 45k, (455), 451, (451), 451, (455),
and odd eighths. To do this they exam- 451. The last price would be placed in
ined all ticker transactions in Bell and Stratum 1; the prices inside of paren-
Howell,and InternationalTelephoneand theses, in Stratum2; the unmarkedprices
Telegraph during April, 1963. They in Stratum 3. It turns out that the clos-
found no significantdifferences. ing price for American Airlines on No-
Although Godfrey's sample covered vember 12, 1964, was 461. Hence, the
all prices and that of Osborne and this openingprice on November 13, 453, also
author included only the closing prices, belongs in Stratum 3. Within each stra-
the conclusionsseem contradictory.This tum, it is important to observe that
paper explores the contradiction, sug- the occurrencesof consecutive fractional
gests that Godfrey'sresults are attribu- prices in a given stock on a single day
table to special characteristicsof the two are not independentof each other. Con-
stocks he studied, and offers a few sug- sider, for example, the transactionsone-
gestions for trading proceduresbased on eighth removedfrom the previous trans-
the findings. action (Stratum2) in a given security. It
is obvious here that if the first transac-
CLUSTER SAMPLING FORCLUSTERED tion one-eighth removed from the pre-
TRANSACTIONS vious price is at an odd eighth, then the
We turn now to a sampling procedure chancesare extremelyhigh that the next
for ascertaining the proportion of all transactionfalling into Stratum 2 will be
transactions in the stock market at even at an even eighth. The proportion of
eighths. The data consisted of the com- transactions falling in Stratum 2 in the
plete record of ticker transactions in cluster units varies less from its true
1964. Our source of data was the Francis value, which turns out to be 0.51, than
Emory Fitch Daily Stock Market Sales would be expected from the binomial
(Blue Sheets) on which the price and formulafor the variance of a proportion
volume of each transactionon the ticker
V(P) _(P) (1-P)
tape are arrangedalphabeticallyby com-
pany name. These transactions were
then grouped into three strata as follows: where P equals the observed proportion
of transactionsat even eighths. Converse
Stratum1. All transactionsat a priceequal to
the previoustransaction. reasoningapplied to sampling in Strata
Stratum2. All transactionsat a price one- 1 and 3 indicates that the binomial for-
5 Niederhoffer,
mula will understatethe true varianceof
op. cit. the proportionof all transactionsat even
6M. D. Godfreyet al., "The Random-WalkHy-
pothesisof Stock MarketBehavior,"Kyklos,XVII eighths.
(1964),1-30. A type of single-stageclustersampling

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 CLUSTERINGOF STOCKPRICES 311

of units was adopted to adjust for this
intercorrelation between transactions.
Seven days were chosen randomly for
each stratum, and a specifiednumber of
stocks, say (M1, n2, . .. , n7) were chosen
by proceedingdown the sheets in alpha-
betical order. For each day, we ascer-
tained the proportionof all transactions
at even eighths within the specifiedstra-
tum in each stock. Hence, for each stra-
tum an estimate of the proportion and
variance of all transactions at even
eighths is provided by the usually used
TABLE 1
INFORMATIONON PROPORTIONOFTRANSACTIONSAT EVEN EIGHTHS
transactions in 1964 falling into Strata
1, 2, and 3 were, respectively, .47, .41,
and .12. Thus our estimate of the pro-
portion of all transactions on the New
York Stock Exchange at even eighths is
given by .47 X P1 + .41 X P2 + .12 X
P3 where Pi, i = 1, 2, 3 equals the ob-
served proportionof transactionsfalling
at even eighths in that stratum.
Table 1 summarizesthe results of this
procedure.For each stratum it shows (a)
the size of the sample, (b) the proportion
of transactionsat an even eighth, (c) the

A B C D Percentage
Classification No. of Proportion Correct Binomial in Total
at Even Variance Variance
Observations Population
Eights of (b) of (b)

Stratum 1 .........10..... I 0 .62 .00074 .00024 .47

Stratum 2 .............. 12,800 .51 .0000029 .00019 .41
Stratum 3 .............. O11,000 .771 .000029 .000018 .12

Total sample estimate.. 24,800 .585 .00017 .000056 .........

formulas for cluster campling with n = correct variance of (b), (d) the incorrect
nl + n2 ... + n7 cluster units.7 That is, binomial variance, and (e) the fraction
n of the universe of all transactionsin the
stratum. Entries in the lowest row give
the estimates for the population values
n
of (a), (b), (c), and (d). (The samplesizes
were determinedlargely by the dictates
and of another investigation; hence they are
not optimum.)
E a - 2PE aimi+P2 m The second line (Stratum 2) of Table
VtP)- (n-1)Xnm2 1 indicates that only 51 per cent of all
transactions one-eighth removed from
wherea, equals, respectively,the number
previoustransactionoccurredat even
of transactionsin the ith cluster unit at the
for the esti-
even eighths, ml equals the total number eighths. The true variance
of transactionsin the ith clusterunit and mate is a mere 19 per cent of the corre-
m = Im /n. sponding binomial estimate. Fully 71 per
Fortunately, from previous investiga- cent of transactions one-quarter of a
tions, we knew that the proportionof all point or more removed from the previous
7W. G. Cochran,SamplingTechniques(2d ed.; transaction
took place at even eighths.
New York:John Wiley & Sons, 1961),p. 65. It is notable that 92.6 per cent of 819

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312 THE JOURNALOF BUSINESS
transactionsone-halfof a point removed
from the previous price fell at even
eighths. However, it must be recalled
that Stratum 3 accounts for only 12 per
cent of all transactions.In line 1 (Stra-
tum 1) we observethat 62 per cent of all
transactionsat the same price as the pre-
cedingtransactionare at an even eighth.
The gross underestimate that the bi-
nomial formula provides for the true
variance in Stratum 1 is the result of a
discernibletendency for transactions at
even (odd) eighths to follow each other.
Finally, a glance at the bottom row
(total sample estimate) discloses the
answer to our question. Approximately
58.5 per cent of all transactions in the
stock market are at an even eighth. The
coefficientof variation for this estimate
is 2.2 per cent.
Now it becomes a simple matter to
reconcilethe results of the variousinves-
tigators. Godfrey and his co-workers
used the completemonthly data for only
two New York Stock Exchangestocks to
test the hypothesisat issue. One of these,
Bell and Howell, was relatively low
priced, and low-priced stocks tend to
show less clustering than high-priced
stocks.8The other stock, I.T. & T. was
then (April, 1963) relatively stable and
active. For example,all of the more than
nine hundred transactions in I.T. & T.
during that month were executed at
prices between 473 and 46.' Therefore,
where the total range of variation was
only five-eighthsof a point, it is reason-
able to assume that very few of those
transactions occurred more than one-
eighth of a point away from the previous
transaction. This would tend to lower
the expected proportion of transactions
at even eighths in Godfrey'ssample.
The present author undertook a sur-
8 Niederhoffer,op. cit.
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vey of the two stocks chosenby Godfrey
et al., but in the month of October, 1964.
It was reassuringto find that 56.1 per
cent of the 581 transactionsin I.T. & T.
occurred at even eighths. In Bell and
Howell, 51.3 per cent of the 254 transac-
tions fell at even eighths.
Instead of limiting himself to two
stocks, Osbornetook a systematic sam-
ple of closing prices during the day of
April9, 1964,of all stocks beginningwith
A-K, in which there were sales of more
than fifty round lots in the week. It
turned out that approximately 55 per
cent of these transactionswereno eighths
removed from the previous transaction.
About 26 per cent of the transactions
were one-eighth away, and 19 per cent
were two-eighths or more removed.9
Supposewe considerthese finalchanges
duringthe day as randomdrawingsfrom
the population of all changes between
transactions.Then an estimate, based on
Table 1, of the proportionof daily closing
prices at even eighths in Osborne'ssam-
ple is
.55 X .62 +.26 X .51 +.19, and
X .71 = .609.
The estimate obtained agrees well with
the value of .608 reported by Osborne.
Our conclusionsare that prices ending
in even eighths do actually occur with
greater frequency than those ending in
odd eighths, and that Godfrey and his
co-workerswere misled by the special
characteristicsof the prices they studied.
DERIVED TRADING METHODS
The sophisticated investor may be
able to utilize this knowledgeof relative
frequenciesfor his own advantage.There
is a further discussion of this subject in
9Osborne,op. cit.
 CLUSTERINGOF STOCKPRICES
a forthcomingarticle.'0It is well to re-
memberthat the congestionresults from
the tendency for the great majority of
limit ordersto be placed at even eighths.
Within this group there is a special pref-
erence for familiar whole numbers like
10, 25, 50, 75, and 100. For example,the
author in anotherstudy receivedpermis-
sion to examinethe book of the specialist
in a well-knowncorporationthen trading
at 79. Forty per cent of the limit orders
to purchasea total of five hundredround
lots rested at the attractive number 75,
and 26.5 per cent of 337 roundlots to sell
were placed at 80.11
Let us considerthe case of a small in-
vestor who recently bought a stock at 72
and would like to sell somewhereabout
80. He would be well advised to place
his sell-limit order at 797 rather than at
80. On the average,therewill be a greater
concentration of sell orders at 80 than
at any other nearby prices. The sell or-
ders create a bearish effect, but the in-
vestor must decide whether the benefits
from a quick sale at 7987are worth the
possiblesacrificeof one-eighthof a point.
On the other hand, if a mutual fund
contemplatedthe purchaseof this stock
after it brokethrough80 and rose to 998,
it might be wiser for them to postpone
the purchase until the issue traded at
10V. Niederhofferand M. F. M. Osborne,"Mar-
ket Makingand Folkloreon the Stock Exchange,"
Journal of American Statistical Association (in
press).
11V. Niederhoffer,"Non-Randomnessin Stock
Prices:A New Modelof PriceMovements"(unpub-
lished thesis, Departmentof Economics,Harvard
University,1964).
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313
100, just long enough to cover all the sell
limits at 100 except for an amount suffi-
cient to match their purchaseorder.The
reason for this is that so many sell-limit
ordersare placed at the fascinatingfigure
of 100 that the great volume of these
orders would act as a resistance to an
advance beyond 100.
A rigoroustest of the validity of these
suggested trading rules is not possible.
In general,the tradingrules are based on
the supposition that a reversal in direc-
tion of price change becomes likely as
price moves to the round number. Some
informationcontained in an above-men-
tioned work12shows that this hypothesis
is true for intervals as short as between
consecutivetransactions.The readercan
verify this effect for yearly highs and
lows by counting, say, the number of
yearly highs or lows from 49' to 497 and
comparing this to the number of highs
or lows from 501 to 50. There are more
highs than lows just below 50 and more
lows than highs just above. Of course,
the proposed rules will change if too
many investors follow them.
The introductionof psychologicalvari-
ables adds one more dimension of com-
plexity to a market system which re-
sponds so sensitively to pressures from
every front of society. If stock market
analysis is to attain the status of a scien-
tific discipline rather than remain an
esoteric cabalistic ritual, we must open
our mathematically oriented models to
embracerealmsof data which have been
almost ignoreduntil recently.
12 Niederhofferand Osborne,op. cit.