Monthly Archives: December 2010

Random Markets? Absolutely Not!

Although my primary intent with this website is to provide my own articles and videos, I do also like to link to quality material on other sites, as it’s discovered by myself or a reader. Today I’d like you to read a four part series written by Adam from SMB Training on the randomness (or not) of market price action. It’s a great series of articles. You’ll find the links down below, following some email Q&A from Aaron (YTC newsletter reader) who discovered this series.

Email Received:

Hi Lance,

I think you would really like this article – right up your alley.

http://www.smbtraining.com/blog/random-thoughts-or-rather-thoughts-about-randomness

It’s an SMB Capital post about the tendency of humans to see patterns reflecting deeper causes when they aren’t actually caused by anything and, in reality, are simply random. Anyway, SMB does a much better job than me at explaining, so I won’t steal their thunder. Hope you’re doing well!

Best,

Aaron

Reply:

Hi Aaron,

Yeah, great article. Thanks. It reminds me of kind of where I was going with my "Support and Resistance on Composite Indices" article.

extract…

…save and then open the excel spreadsheet available from this link.* This is a random number generator which displays its output as a series of 200 price bars, and their corresponding RSI. You’ll see the rules it uses for construction of the price bars above the chart display. Press F9 as many times as you wish to see further charts, once again based on a new sequence of random numbers. (I’m not sure of the influence the programming of the excel random number function would have on validity of data – I’m operating on the assumption that it’s close enough to random).

The interesting observation from this is that random data when plotted in price chart format appear quite clearly to show characteristics of financial charts. Pressing F9 multiple times and you’ll see all kind of chart formations – trends, support & resistance, head and shoulder patterns, triangles, double tops / bottoms etc.

This is not evidence of the random walk concept. The fact that random data appears to share the same characteristics as financial charts, does not mean that financial charts are random. In fact, I’m told that when comparing plots of the standard deviation of price closes vs the same for random data, the result is quite different. Random data forms a nice normalized bell curve. The financial chart data apparently is more narrow in the body with a very wide base, indicating greater periods of consolidation which are separated by larger than random impulse moves. So I’m told anyway – I don’t have any proof of this and am in fact not a statistician. The point is though, financial markets are not random.

What this might mean though, is simply that our mind is very good at seeing patterns in data.

Amazing stuff.

It would be an interesting experiment to trade a number of sessions of completely random data, to see if I could profit from it with the same level of performance as in the real markets. I imagine it would have to be done such that I did not know that these sessions were not ‘real’ so as to remove any influence that knowledge may have psychologically.

I’m not sure what the results would mean exactly. If I was profitable then I imagine it would mean that my results are solely a function of my psychology and money management; and have nothing to do at all with my strategy which has been developed based on my understanding of the nature of the markets.

Interesting.

Regards,

Lance Beggs

Followup SMB blog posts:

The original article, linked to above, was followed by four further articles. Links for all six parts follow:

Part 1 – Random thoughts (or, rather, thoughts about randomness)

Part 2 – Another look at randomness

Part 3 – Randomness: the answer key

Part 4 – Volatility clustering: one way that markets are NOT random

Part 5 – Randomness revisited: random levels?

Part 6 – My list: some ideas for finding tradable edges

* I am unaware of the source of this xls file… if anyone knows it’s origin, please advise so that I can credit the source.

Micro-Channel False-Breakout Counter-Trend Entry

Entry to a counter-trend trade can be difficult to time, especially when it’s not in the vicinity of any significant S/R level.

And particularly when it just keeps grinding a little further, then a little further again; always offering what appears to be tempting entries.

(Note: the example here uses a trading timeframe of 1 min, with a 20 tick lower timeframe… but the concept is equally applicable on longer timeframe combinations)

 

 

Let’s look at a lower timeframe, where we time entries to trades:

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Acceleration Into S/R – Wait For the 2nd Chance Entry

Monday’s emini-Dow session offered two great examples of the higher probability way of trading a reversal at S/R, when price accelerates into the area.

The examples occurred on the 10 tick chart, which I’ve been using as my lower timeframe lately, however the concept is applicable on all timeframes and markets (provided they offer suitable liquidity for trading).

Acceleration is easy to spot through the angle of price movement, although other features can assist in identifying acceleration into S/R. Often it’s associated with a large increase in volume; and you’ll usually see a dramatic increase in “daylight” (the gap between the price bars and the moving average).

In these two examples, price was moving down towards the 11355 support which is also the high point of price action from the prior Thursday.

Fading the strength associated with this acceleration usually offers a lower probability opportunity, despite the fact that it occurs at an S/R level. It’s usually better to wait for a second chance entry, as price retests the level and again fails to break S/R.

Entry is taken on a break above the stall on the second test. Stops are easily positioned below the price action lows and/or area of S/R. Targets… well it depends on your strategy.

 

 

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What We Fear In Trading Is…

A key component of my trading documentation is my Lessons Learnt Journal – a collection of insights organised into numerous trading-related categories. It creates a great tool for both formal review and learning, and also for casual reading whenever I’ve got a spare few minutes.

Within this invaluable resource, and amongst the numerous market structure and price action insights, is my favourite "lesson learnt"… a short psychological gem…

What we fear in trading is the loss of our self.*

What does this mean?

Our definition of who we are is built up through our achievements, our successes or failures, our possessions, our victories, our job, our financial situation, our families and friends perception of us, our belief as to others perceptions of ourselves, and so on.

This is our self-image. It’s how we perceive ourselves as a person.

Our current life circumstances are a direct result of our self-image.

And our future decisions and actions will be further influenced by it, as we act in order to reinforce our self-image, or to resist or avoid any potential threat to our self-image.

This is important… subconscious decisions and actions will be taken in order to protect our self-image from any perceived threat.

For most novice traders, trading failure IS a threat to their self-image.

We may see ourselves as confident, intelligent, successful people. We expect success at new ventures, especially one so potentially life-changing as trading. But we also subconsciously recognise that the market environment is unlike any other we’ve worked in before, and contains risk along with significant potential to fail at this venture. To the novice trader, who has not mastered their own trading psychology or mindset, trading failure means that perhaps they’re not confident, intelligent, successful people. Maybe their self-image was an illusion, or a lie? Maybe they’ll never be able to attain wealth? Maybe they’re not able to provide for their family? Maybe they won’t ever be free from the slavery of a nine to five job? Maybe their partner won’t love them any more? Maybe they won’t be worthy of self-love any more?

Every loss contains within it the seeds of potential failure. Not just loss of funds, but proof that our self-image is a lie; a fragile idea that quite possibly has no basis for reality. In every trade… we risk our belief about who we.

Recognising this threat, our subconscious will act to protect us from potential loss. Some of us become busy preparing to trade; avoiding risk through planning and researching rather than ever engaging the live market. Others fail to plan, so that they can’t blame themselves for the likely failure. Others actively seek out other sources of blame – their broker who hunts stops; their chat-room moderator who obviously is a fraud. Others hesitate on entry, in order to avoid what could be another bad trade. Others hold trades that have moved through their stop, in the desperate hope they’ll come back to breakeven, or even profits. And others exit profitable trades earlier than defined in their plan, to secure these profits before the unpredictable market can turn around and take away their money.

We make these decisions and actions to protect ourselves from perceived threat; but we do so completely unaware of their unintended consequences. The fact that our subconscious actions, taken to protect us from loss, act instead to produce the very failure that we seek to avoid.

Trading can be a cruel game (for the novice).

Lance Beggs

* Source: Lessons Learnt entry adapted from the quote "You cannot separate any fear that you have from the fear of the loss of your self" by Guy Finley in his spirituality presentation, "Timeless Mind".

Price Action – Lagging or Leading?

The following is an excerpt from an email response to a trader who suggested that, “Price Action Trading is a lagging indicator (albeit short lagging indicator) methodology based on one’s reading of the future price direction through market/trend analysis with active management designed to scratch trades early if the market suggests one is incorrect on the future price.

I understand completely what they’re saying; they’re essentially correct; although I have some concern over the use of the term lagging. Price action analysis is not about the past… but about the future.

Here’s my email response…

While it’s true that previous price bars show what occurred in the past, the current price bar shows what is happening right now. Our focus is not in the past but instead in the present and the future.

Situational awareness involves three components… perception of environment (what’s happening), understanding the meaning (what does that mean), and projecting forward in time (how will that impact me in future).

We aim to maintain situational awareness within the markets via (a) conducting analysis of the current price action (what’s happening), (b) considering the current action within the context of previous action, and identifying signs of strength and/or weakness (what does that mean), and (c) projecting that forward to identify areas where other traders may be exposed to stress and forced to act, thereby creating orderflow required for profit (how that will impact the future).

Essentially, we’re creating IF-THEN statements about future possibilities, then carrying out the appropriate actions based on whichever scenario develops.

eg. refer to the following chart:

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