Winning streak? It is all in the figures!

Here we go for a technical discussion today. We have all heard that markets are more or less random, as it represents the opinions of millions of investors or traders, and of course, they don’t usually agree with each other, the proof is that there seems to be always some who wants to sell you some stuff when you want to buy it.

So prices may look random but there is a positive bias because prices can not be negative. So normal curve distribution is not applicable. See when Bollinger bands go into negative territory, you know the objective is invalid!

So let’s assume for the exercise that we have a 55% chance that tomorrow price will be higher than today, so 45% risk they are lower. What is longest series of positive consecutive days?

Any idea?

Hint:  we need to use the law of large numbers.

The formula is:

-ln(number of observations)/ln(probability)

So the longest streak of consecutive winning days for 100000 days observed is -ln(10000)/ln(.55) = 19 days and same calculation yields a 14 consecutive loosing days.

Yes, that is what swing trading is about. Anticipate these streaks of consecutive winning or loosing days and play them accordingly.

The same goes with goes with your trading strategy. The probability lays in your own skills to define a winning system. You need to backtest with as much data as possible. A system that is winning 85% of the time can still yield 6 consecutive loosing trade (but also 70 consecutive winning trades ;-))

What happens with robots trading? There are 2 points to consider:

1. Robots have been programmed by human. So they just replicate our trading strategy. So same as above applies

2. Robots can be taught to learn (machine learning, neural networks). After some time they will all more or less reach the same strategy and so they will ‘see’ same thing, so market will become flat and cancel out robot trading efficiency if any.  Some news (real or fake) will be needed to move the market. Robots will learn to cheat and will need support from humans!

So as conclusion, you need a strategy with an edge to catch swings or trends, they are predicted by the random nature of the market. You can protect your strategy by:

1. Not sharing it. Keep it secret.

2. incorporate elements that can’t be automated (e.g. action-reaction lines)

3. Incorporate strong psychological elements. Trend traders for instance do not have more than 30% success rate for their trades. Meaning they may have to endure 32 loosing trades in a row! Without excellent money management and psychological force to endure this, you blow out your portfolio and yourself in no time! But you can also catch the huge moves!

With volatility trading, I can reach 60% success rate on trades, so easier to stand psychologically, up to 85% in very volatile markets.

The hidden beauty of volatility bands?

You may have wondered why in previous post I talked about action-reaction lines for trading. This is very technical and manual but the principle will be re-used.

Volatilty bands do already exist. There are Bollinger bands (based on standard deviations) or Keltner bands (based on ATR). Is that it?

No someone created also the ‘better Bollinger bands’ (sic). See some code here: https://www.prorealcode.com/prorealtime-indicators/better-bollinger-bands/

Volatility still is little explored. You know when you are on the right path when it becomes simple.

Look at those bands. If green, go long! (Consider long term trend of course)

This one is even more fun. Formula is deceptively simple. And there seems to be linearity in the market!!! Of course, humans think in straight lines! Just follow them and trading becomes profitable

Can you anticipate market direction?

If there is field relatively unexplored, it is volatility. Because you need to throw away the gaussian curve and look the market in the eyes. Obviously you can what it is doing just now, but do you know where it goes?

Most traders have given up on forecasting, they are merely following the trends. But we are talking human perception and analysis. As many studies have show, human mind decisions can be anticipated with some success and that that should be enough to get an edge.

Let’s start. Here you can see price of gold in € some time ago. Do not worry about multiple lines already displayed. A green arrow indicates there should be some buying opportunity. So?

Let’s go back a little bit and and look at the waves.

Now if you patient engouh, look into Dr Andrew, creator of pitchfork and browse to action-reaction lines. Now the fun begins. Pitchforks and reactions lines by extent capture trend and volatility at the same time. As strange as it seems, volatility can be anticipated. Of course, you know quaterly results date, right? So you expect some move. Acttion-Reaction (AR) lines do anticipate this.

Let’s trace the center line (you need research to be able to find which one is best). Then trace the AR lines.

The space between the lines is volatility in 2-dimensional space: time and price!

According to theory, price should stop on one of the next reactions lines

Fast forward in time!

First line is ignored by market. Then we get  tops on reaction lines. Not just one time but twice!

Wonderful!

Why you need to love volatility

You probably have read in many places that volatility is a monster that will eat your portfolio.

Let’s start from zero: volatility over a year is how much price have in whatever direction.

Now look at this one:

Price have risen from 10€ to 20€ in an  almost straight line. So volatility is roughly 100% and you don’t want to be in? No kidding!

Next time we will see how to observe volatility and how it evolves to a trend.

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