Friday, October 25, 2019

Learning to Trade - 2: Understanding Cycles and Context

In the first post in this series regarding learning to trade, we explored a foundation that enables us to see three things:  1)  who is in the market; 2) what they are doing; and 3) the prices at which they are doing it.  The goal is to achieve an understanding of the market's auction process, tracking the actions of buyers and sellers and their ability to move markets to new levels of value.  

Uniting these three elements are the concepts of cycle and trend.  Trend refers to the linear, directional tendency of the market over given time horizons.  Using Market Profile as a conceptual framework, a trending market is one in which we build levels of value at higher or lower price levels.  Cycles refer to patterns of rising and falling both across and within market trends.  Cycles vary in their frequency (shorter/longer term) and in their amplitude (shorter, choppier oscillations/larger ranges).  Like snowflakes, no two cycles are identical and yet each has a common structure.  The start of a cycle consists of a sharp upward momentum move, followed by lower volatility choppiness and topping, followed by a momentum move downward.  In uptrends, cycle lows will occur at successively higher price levels; in downtrends, we see lower price highs.  When longer-term trends reverse, it's not unusual to see extended periods of cycling between momentum moves.

When we place a good directional trade, we are using shorter-term cycles as information to help us find good risk/reward spots to participate in trends.  When we place a good "mean-reversion" or reversal trade, we are using shorter term cycles as information to help us find good risk/reward spots to fade extremes in longer-term cycles.  Good trading thus consists of placing market behavior in context:  using shorter-term information to help us exploit longer time frame moves.

One of the challenges of identifying cycles and context in markets is that the time series of prices is typically not stable (stationary).  During some times of day, we are busier; other times we are slower.  Some market periods show more movement; others less.  If we don't have stability in what we're trading, it is difficult to accurately generalize from the past to the future.  The analogy I often use is card-counting.  If we're drawing cards from a single deck, counting can be quite effective.  If we draw cards from multiple decks and continually shift the number of decks in the "shoe", counts will provide little information.

When traders focus on chart and technical indicator patterns, they are capturing some facets of trend and/or cycle, but these facets shift as we move forward with different volume and volatility.  Such patterns--described by traders as "setups"--often lack context, so that they do not reliably capture the cycles and trends within which shorter-term market behavior is nested.

One way I address the need for more stable price series is to capture price as a function of volume, rather than as a function of time.  A simple example of this would be to draw new bars every time we trade, say, 5000 futures contracts or 100,000 shares of stock.  During busier times, we draw more bars; slower times provide fewer bars.  Creating charts in event time helps us perceive and measure cycles more readily.  Event time also helps us capture relationships among the various phases of market cycles.

I realize this is throwing a lot of conceptual content at you.  Upcoming posts will illustrate all these concepts and eventually will lead to the new style of trading that I am teaching myself.  The main thing is to appreciate that understanding supply and demand is key to identifying trading opportunities, and placing our understanding in context is key to translating our market ideas into effective trades.

Further Reading: