Signal decay
Why does a trading pattern stop working once many traders notice and use it?
In plain words
Signal decay is the gradual weakening of a trading pattern's predictive power after it becomes widely known. As more traders act on the same signal, their orders move prices earlier and leave less of the pattern's usual move available to capture.
Why it matters
A rule tested on historical data may have worked because few traders used it. Once crowded, the pattern's entries become more expensive and its exits arrive sooner, so positions sized on past results can underperform or reverse sharply.
In a real week: BTC, week of 1 March 2021
In the week of 1 March 2021, BTC rose 12.93%, with volume about equal to its prior 12-week average, while BTC closed in the upper third of its range (78.3%) at the 86th percentile of 159 weeks of history. Three of the previous four weeks were up. A widely followed buy-the-dip pattern with no corresponding surge in trading interest may indicate that fewer participants remain to extend the move.
A common mistake
Assuming decay is permanent. Attention fades, participants exit, and an old pattern can work again, though timing is unknowable in advance.