How far will the market go?

When you want to know where price is going to go, there are many ways to guess. Among others:

1. Return to average. If price go too far away from average, then they are likely to go back to average

2. Fibonacci retracements and extensions

3. Check analysts price objective

The weakness is the same for all: when? in one swing or after many up and down swings?

With volatility trading, we can answer thoroughly two different ways

1. The drunkard’s walk

The concept  of ‘drunkard’s walk’ was introduced by  William Feller by the following math problem:
If a drunk guy leaves the lamp post he is leaning against, how far would he have gone, on average, after n steps?”

The answer is he would have gone the square root of n multiplied by the average length of his stride:

√n * Average length of stride

Here is how to translate for price objective setting: start from a major price bottom, the first objective that should be reached within n days is the average price change (or Average True Range)

Example: if we look at an ATR over 25 periods (days, weeks), the first objective that can be reached in 25 days is lowest low (the lamp position) plus 5 x ATR25.

Easy, right? If objectif is not reached, then just give up.

When we say first objective, it is because we are considering a random walk, but if a trend is given birth (or the street has a slope for our drunkard), then prices may go much further away and you need to re-estimate the new objectives with each swing low.

2. Action-reaction

The usual way to use action-reaction is enclose price action into channels, so as to get high probability entry points. Also the distance between lines gives the potential objectives in straight lines.

I am removing previous lines for clarity but I am now drawing an other set of lines. Distance between the lines also indicates potential

By having two sets of AR lines on the chart, crossing of lines indicate precisely where prices are going to go. There may be several possible objectives, but many can be discarded (too sloppy change required, or objective in the past)

See here yellow highlighted target reached almost on time (depending on accuracy of lines drawing)

That’s it! Because we are analyzing price and time together (aka volatility), we are reaching high quality trading

Volatility trading? Hmmm…

All the content on this website will be original. No lessons about Bollinger bands or how Average True Range is calculated.  This first post will reposition volatility trading with respect to other kinds of trading.

For this purpose, let’s travel east to reach China. They have theories like Yin and Yang but the one that interests us more here is the 5 elements theory. According to it, plants, humans, animals are all driven by a cycle including 5 elements: wood, fire, earth, metal and water. There are 2 cycles actually, one for creation and one for destruction. The market being driven by humans, and robots are programmed by humans so are no exceptions, this cycle to market themselves!

A stock has been issued by a company, this is the wood. Then wood generates fire, price is matter of hot arguments we need lots of computer to finalize. The way prices go and up and down each is volatility, it is earth, it is linked to muscles, so the market is shaping up. Then from the volatility appear trends, which is kind of illusion that prices are going in one direction. Once trend appear, volumes change; volumes are like water of the river, they make the market. When price goes up in a trend, then volumes go down as nobody wants to sell before the trend is over. Volumes in turn change the company; if lots of money flows in, then they have capability to invest and this in turn will change the price of the company. Cycle is over!

From a trading perspective, you can position yourself wherever you want:

  •  At stock level, traders carry out fundamental analysis. Their strategy is usually buy & hold and they want to catch dividends for the money you invest in. They don’t usually care too much about the actual price, saying it doesn’t matter. They come up with funny price  objectives by comparing with other companies in same sector and when the stock plummets, they say they keep it for long term!
  • At price level, traders are usually day traders, order book traders, robots… They draw lines which they call support or resistance. They of course totally disagree with one another, given they are not looking at the same chart with same time frame.
  • At volatility level, there is … almost nobody. Nobody is pure volatility trader. People hate volatility (subject of another future article). Bollinger himself agreed his bands are far from perfect. Keltner also paved some way. This area is still not much explored. The point is you need to ‘see’ things in all this random data that is the market. It gets lots of convoluted mathematics to play here. But the rewards are great
  • At trend trading level, one will meet sour guys. Why? Because they are blamed any time the market plummets, as they openly say they play both upside and downsides of the markets. They may have low success rate but when they win, they win big,  and so an overall positive expectancy
  • At volume level, traders have lots of money to manage. So they can call the company’s CEO and advise on the strategy or the volumes might just die, right?

That’s it. There are times when you need to trade price level (sideways markets), other times when trend is a better choice , or dividend playing at some other time. We need to get an edge to enter the market and to exit.

Until next time, trade safely from the right perspective.