Are the markets efficient?

It is a theory that has been in the air for quite long time that says that the price at any time reflect all the information available to investors.

Read again what I have just written!

How can this be true? what is the fair price of a security with all information available? Is there any magic formula for this? And why would it be valid for every one and all the time? Why does the price keep changing every day?

True enough, there are organizations (banks, Hedge funds, …) that have implemented in their system a formula based on statistical analysis. The inputs are usually price earnings ratio, price to book value, … and a few dozens others like ‘is surprise earning having any significant impact on price?’. Then they analyze real-time(!) all the information available in media, social networks, … and compute a ‘fair’ price, decide whether the security is under-priced and then they take position. Not on a daily or weekly chart! No on a 3-minutes chart! Because competition is sharp, they come up with same conclusions, and prices usually catch this fair price in a couple of hours. Risk is very limited for them! And so markets are efficient from this perspective.

For the average investor, unfortunately, this does not work unless you can buy yourself one mainframe computer and have programming skills and can analyze big data.

But markets are still moving in other time frames! Because price is made of the opinion of huge number of investors, be they humans or robots or martians, … and nobody thinks exactly like his neighbor. Reasons are linked to the security itself or external, e.g. you need cash to buy yourself a coffee! The result of this processing can only be random and you would be right questioning the market efficiency. I have proven in previous article that trends emerge out this random process and that is one of the best way to make money and beat the market!

So have fun with random processes, dig in whatever good books exist on the subject.

Why you need to master probabilities…

Everybody hated probabilities in high school. The exercises like a bag with 20 red balls and 30 black balls, draw 2, what is the probability of having 2 black balls?

Trading is managing your luck at playing with a system that is random, and any forecast you make has non-zero chance to be wrong! In other words, you are not trading the market, you are trading a belief that the market will go (or continue to go) in one direction for some time to make profits. You must not leave that to anyone having no interest in probabilities.

Take the example of weather. You are not asking climatologist about the weather next week. Climatologists focus on long term climate change and whatever happens in the weeks or even months is insignificant; in other words it is noise! Meteorologists, on the opposite, are concerned by the short term, they have made a model in which they believe, after having tested many weather conditions and they bet on something likely to happen, e.g. sunny weather, and sell this information to their customers. You know weather forecasts are never perfect but they are improving as more and more data and computing power is made available to them!

Same goes with trading. Economists are interested in long term economic cycles (Kondratieff, …) and so their comments on many TV channels why S&P500 is up 0.5% because (un)employment shows an increase of 0.3%. Not only is 0.5% up or down on market index is noise, but there is surely no correlation at all, if you would look at data from the past.

Traders main interest should and must be how to have a system that can say with a level of certainty where the market is going in the short term. The model the trader is using should have a positive expectation, i.e. being profitable over long periods.

Yes, but sometime, the weather is sunny for very long time, and nothing happens? Correct! And for trader, it is the same. When market is too quiet or too much random (like it is now), trader must refrain from trading and risk blowing up his account

Trade safely, use stops, and don’t forget to wash your hands!

Markets are correcting, aren’t they?

Sorry I have not written for a while. Thank you very much for your encouraging comments. Yes it is true, luck is an important factor in trading and it needs to be factored in when working on any trading strategy. The question is always the same: how do you manage the unknown? The fact is that when the brain has seen something, which we may call a pattern, it is looking for evidence that it is there and reveal something. We are not accustomed at at all to challenge the existence of pattern.

Let’s take an example. Here is a list of numbers: 2 , 4, 6. What is coming next?

Most likely you are going to say 8, right?

In fact, had you answered 25 it would have been an ok answer because I only about 3 consecutive higher numbers. No other rules.

When you see a pattern next time on a chart, take time to challenge it!

Now let’s look at S&P500 and recent price action.

You do not need 20 indicators. A ROC-L (created by Alexander Elder – it is a ROC 21 days applied to 13 days exponential moving average) is good enough, quite smooth. There was a divergence on the top and signal to sell was there (red color)

That’s it. I am not looking for any other confirmation. Market has been on a long streak of winning weeks. Whatever the reason (Fed printing money by billions, or chinese virus, …), the market was bound for some other direction.

I explained previously (did I?) that the market is statistically NOT a normal distribution so don’t rely on Bollinger bands to anticipate. We are much better off with action-reactions lines (the big idea behind Andrew Pitchfork) because if prices have gone away from center line in one direction, then it is likely they will do so on the other side. Concept is simple, the secret is where to draw the center line. I need to write a book about this, since Andrew never went to such details.

So finance suddenly realizing impact of Covid-19, prices have dropped in 2 days to their second reaction line. The 2 lines below close to each other should prove a better support.

Let’s be clear, we are bearish now, with something that looks like the beginning of a bearish short term trend. I can change my mind above 3300, this number will of course go down in coming days. On a longer term basis, the bullish trend is of course still valid as long as above 3100 on weekly chart, and 2840 on monthly chart.

Due to the weight of index based ETF’s, it does not make too much sense to look for opportunities on major stock. But volume might be small on small caps making trading also risky.

Until next time, trade safely.

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.

Until next time, trade safely

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:

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

Apple Weekly

Until next time, trade safely

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!


Trade safely until next time

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.

Trade safely

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