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: 06-09-2016 14:45 UTC

REFERENCES
Linked references are available on JSTOR for this article:
http://www.jstor.org/stable/2351480?seq=1&cid=pdf-reference#references_tab_contents
You may need to log in to JSTOR to access the linked references.

JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted
digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about
JSTOR, please contact support@jstor.org.

Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at
http://about.jstor.org/terms

The University of Chicago Press is collaborating with JSTOR to digitize, preserve and extend access to
The Journal of Business

This content downloaded from 148.210.229.184 on Tue, 06 Sep 2016 14:45:40 UTC
All use subject to http://about.jstor.org/terms
 A NEW LOOK AT CLUSTERING OF STOCK PRICES*
VICTOR NIEDERHOFFERt
T HE psychology of numbers is a fas-
cinating subject which should re-
ceive more attention from stock
market analysts. Until recently there was
little systematic research in the field.
Leads can be gathered from the work in-
other disciplines. Motivational research-
ers have convinced merchandisers that a
sales price of $2.99 is a far more attrac-
tive figure for the purchaser than one of
$3.00. It is common knowledge among
policy bookies that thousands of players
will flock to place their bets on the same
number at the occurrence of some un-
usual symbolic event.
The literature of the stock market con-
tains similar illustrations: from Gann
writing in 1930,1 who found that "The
popular trading prices are 25, 40, 50, 60,
75, 100, ... ."; to Wyckoff in 1963,2 who
declared that "We think in round num-
bers and try to sell at round numbers."
The violent, short-run movements of
the stock market averages are frequently
ascribed to heavy public buying 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
This content downloaded from 148.210.229.184 on Tue, 06 Sep 2016 14:45:40 UTC
All use subject to http://about.jstor.org/terms
cated analyst would do well to study the
effect of investor psychology upon price
movements in stable situations as well as
in times of bandwagon buying or stam-
pede selling.
Such an approach is particularly rele-
vant to an understanding of the contro-
versy surrounding the theory that stock
market prices ending in even eighths
occur far more frequently than prices
ending in odd eighths. The evidence seems
to show that this peculiar phenomenon
depends to a large degree on the predi-
lection of investors to place orders at
round numbers. Almost all market orders
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 clustering at
round numbers, which are, of course,
numbers ending in an even number of
eighths.
Osborne appears to have been the first
one to test this rigorously.4 He sampled
the closing prices of 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
confirmation of 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 JOURNAL OF BUSINESS

obtained by the present author whose
data included the closing prices of five
consecutive samples of two hundred
stocks whose prices remained unchanged
for the day and were selling at a price
below 50. The proportion of all closes at
the even eighths was .66.1
Godfrey and his co-workers6 also at-
tempted to test the frequencies of even
and odd eighths. To do this they exam-
ined all ticker transactions in Bell and
Howell, and International Telephone and
Telegraph during April, 1963. They
found no significant differences.
Although Godfrey's sample covered
all prices and that of Osborne and this
author included only the closing prices,
the conclusions seem contradictory. This
paper explores the contradiction, sug-
gests that Godfrey's results are attribu-
table to special characteristics of the two
stocks he studied, and offers a few sug-
gestions for trading procedures based on
the findings.
CLUSTER SAMPLING FOR CLUSTERED
TRANSACTIONS
We turn now to a sampling procedure
for ascertaining the proportion of all
transactions in the stock market at even
eighths. The data consisted of the com-
plete record of ticker transactions in
1964. Our source of data was the Francis
Emory Fitch Daily Stock Market Sales
(Blue Sheets) on which the price and
volume of each transaction on the ticker
tape are arranged alphabetically by com-
pany name. These transactions were
then grouped into three strata as follows:
Stratum 1. All transactions at a price equal to
the previous transaction.
Stratum 2. All transactions at a price one-
5 Niederhoffer, op. cit.
6M. D. Godfrey et al., "The Random-Walk Hy-
pothesis of Stock Market Behavior," Kyklos, XVII
(1964), 1-30.
eighth removed from the previous
transaction.
Stratum 3. All transactions at a price one-quar-
ter or more removed from the previ-
ous transactions.
For example, the prices of the first
eight transactions in American Airlines
on November 13, 1964, were respectively,
451, 45k, (455), 451, (451), 451, (455),
451. The last price would be placed in
Stratum 1; the prices inside of paren-
theses, in Stratum 2; the unmarked prices
in Stratum 3. It turns out that the clos-
ing price for American Airlines on No-
vember 12, 1964, was 461. Hence, the
opening price on November 13, 453, also
belongs in Stratum 3. Within each stra-
tum, it is important to observe that
the occurrences of consecutive fractional
prices in a given stock on a single day
are not independent of each other. Con-
sider, for example, the transactions one-
eighth removed from the previous trans-
action (Stratum 2) in a given security. It
is obvious here that if the first transac-
tion one-eighth removed from the pre-
vious price is at an odd eighth, then the
chances are extremely high that the next
transaction falling into Stratum 2 will be
at an even eighth. The proportion of
transactions falling in Stratum 2 in the
cluster units varies less from its true
value, which turns out to be 0.51, than
would be expected from the binomial
formula for the variance of a proportion
V(P) _(P) (1-P)
where P equals the observed proportion
of transactions at even eighths. Converse
reasoning applied to sampling in Strata
1 and 3 indicates that the binomial for-
mula will understate the true variance of
the proportion of all transactions at even
eighths.
A type of single-stage cluster sampling

This content downloaded from 148.210.229.184 on Tue, 06 Sep 2016 14:45:40 UTC
All use subject to http://about.jstor.org/terms
 CLUSTERING OF STOCK PRICES 311

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

TABLE 1

INFORMATION ON PROPORTION OF TRANSACTIONS AT EVEN EIGHTHS

A B C D Percentage

Classification No. of Proportion Correct Binomial in Total

Observations Eights
at Even Variance Variance Population
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 transactions in the
stratum. Entries in the lowest row give
the estimates for the population values
n
of (a), (b), (c), and (d). (The sample sizes
were determined largely 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
where a, equals, respectively, the number
the previous transaction occurred at even
of transactions in the ith cluster unit at
eighths. The true variance for the esti-
even eighths, ml equals the total number
of transactions in the ith cluster unit 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 proportionpoint of allor more removed from the previous
transaction took place at even eighths.
7 W. G. Cochran, Sampling Techniques (2d ed.;
New York: John Wiley & Sons, 1961), p. 65. It is notable that 92.6 per cent of 819

This content downloaded from 148.210.229.184 on Tue, 06 Sep 2016 14:45:40 UTC
All use subject to http://about.jstor.org/terms
312 THE JOURNAL OF BUSINESS
transactions one-half of 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 observe that 62 per cent of all
transactions at the same price as the pre-
ceding transaction are 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
discernible tendency 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
coefficient of variation for this estimate
is 2.2 per cent.
Now it becomes a simple matter to
reconcile the results of the various inves-
tigators. Godfrey and his co-workers
used the complete monthly data for only
two New York Stock Exchange stocks to
test the hypothesis at issue. One of these,
Bell and Howell, was relatively low
priced, and low-priced stocks tend to
show less clustering than high-priced
stocks.8 The 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-eighths of a point, it is reason- co-workers were misled by the special
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's sample.
The present author undertook a sur-
8 Niederhoffer, op. cit.
This content downloaded from 148.210.229.184 on Tue, 06 Sep 2016 14:45:40 UTC
All use subject to http://about.jstor.org/terms
vey of the two stocks chosen by Godfrey
et al., but in the month of October, 1964.
It was reassuring to find that 56.1 per
cent of the 581 transactions in 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, Osborne took a systematic sam-
ple of closing prices during the day of
April 9, 1964, of all stocks beginning with
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 transactions were no 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
Suppose we consider these final changes
during the day as random drawings from
the population of all changes between
transactions. Then an estimate, based on
Table 1, of the proportion of daily closing
prices at even eighths in Osborne's sam-
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 conclusions are that prices ending
in even eighths do actually occur with
greater frequency than those ending in
odd eighths, and that Godfrey and his
characteristics of the prices they studied.
DERIVED TRADING METHODS
The sophisticated investor may be
able to utilize this knowledge of relative
frequencies for his own advantage. There
is a further discussion of this subject in
9 Osborne, op. cit.
 CLUSTERING OF STOCK PRICES 313

a forthcoming article.'0 It is well to re-
member that the congestion results from
the tendency for the great majority of
limit orders to 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 another study received permis-
sion to examine the book of the specialist
in a well-known corporation then trading
at 79. Forty per cent of the limit orders
to purchase a total of five hundred round
lots rested at the attractive number 75,
and 26.5 per cent of 337 round lots to sell
were placed at 80.11
Let us consider the case of a small in-
vestor who recently bought a stock at 72
and would like to sell somewhere about
80. He would be well advised to place
his sell-limit order at 797 rather than at
80. On the average, there will 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 7987 are worth the
possible sacrifice of one-eighth of a point.
On the other hand, if a mutual fund
contemplated the purchase of this stock
after it broke through 80 and rose to 998,plexity to a market system which re-
it might be wiser for them to postpone
the purchase until the issue traded at
10 V. Niederhoffer and M. F. M. Osborne, "Mar- tific discipline rather than remain an
ket Making and Folklore on the Stock Exchange,"
Journal of American Statistical Association (in
press).
11 V. Niederhoffer, "Non-Randomness in Stock
Prices: A New Model of Price Movements" (unpub-
lished thesis, Department of Economics, Harvard
University, 1964).
100, just long enough to cover all the sell
limits at 100 except for an amount suffi-
cient to match their purchase order. The
reason for this is that so many sell-limit
orders are placed at the fascinating figure
of 100 that the great volume of these
orders would act as a resistance to an
advance beyond 100.
A rigorous test of the validity of these
suggested trading rules is not possible.
In general, the trading rules are based on
the supposition that a reversal in direc-
tion of price change becomes likely as
price moves to the round number. Some
information contained in an above-men-
tioned work12 shows that this hypothesis
is true for intervals as short as between
consecutive transactions. The reader can
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 introduction of psychological vari-
ables adds one more dimension of com-
sponds so sensitively to pressures from
every front of society. If stock market
analysis is to attain the status of a scien-
esoteric cabalistic ritual, we must open
our mathematically oriented models to
embrace realms of data which have been
almost ignored until recently.
12 Niederhoffer and Osborne, op. cit.

This content downloaded from 148.210.229.184 on Tue, 06 Sep 2016 14:45:40 UTC
All use subject to http://about.jstor.org/terms