The central conundrum to every trader is the question…..are the markets random or not The reality however is that the market is a random walk much of the time punctuated with periods of non-random directed price behaviour. The market exhibits behaviour characterised by fat tails. What this means in statistical terms is that markets carry more risk than what normal distributions characterised by random Brownian motion imply.
The way we here at ATS tend to treat the trading game is akin to a problem with thermodynamics. Look at the features of the collective as opposed to the mechanics of the parts. The activities of participants in a complex system such as the markets gives rise to GROSS statistical features of the markets themselves such as the overall volatility and market structure. It is not the individual buy/sell and trade size decisions of each participant that gives rise to the Gross statistical features of the market but rather the collective activities of participants that do.
This collective action gives rise to gross features of price such as divergent and convergent momentum just like the waves in the ocean and these features tend to become more ‘enduring’ when participant behaviour becomes coordinated….but more often than not, the vast differences in participant behaviour give rise to apparent features that are simply no more than a random collective summation of these activities. Indicators inherently rely on a particular set of circumstances to unfold in relation to price to indicate a future predictive outcome….but they are often too prescriptive in nature. Emergent features of collective price action can take many forms.
It is more a game of constructive and destructive interference when you sum up all the activities of the participants just as the overall features of a cloud are governed by the summated activities of the mechanics of its individual water molecules.
Market structure is an ’emergent’ feature of collective participation. More often than not the price action is a pure random outcome based on the summated constructive and destructive impacts of the participants…..but occasionally the emergent feature has ‘real’ substance that persists for an extended period and reflects overall participant behaviour.
If we base our trade forecasting decisions on price action alone we will find it extremely difficult to achieve a result that is anything other than a random outcome…..but if we base our forecasting decisions on the mechanics of all participants over a period of time reflected by Gross features, then it is more likely that we will be able to jump on board the enduring features of the market when they are present. That therefore provides a way to capitalise on the gross features by only taking part in a trade when these activities are more likely to be more coordinated than the everyday chaotic behaviour. For example if we were trading the weather, we would avoid the normal days and only trade during the storms when the gross ensemble are more likely to behave in a coordinated manner. Some of these storms will turn out to be cyclones/hurricanes and this is where your bread and butter will be borne. All other activity will simply be a churn and random outcome.
Now everyone knows when a storm is upon them and these storms take many forms and shapes…..but it is almost an impossible task to predict them. That’s why we prefer to ‘follow price’ rather than ‘predict it’….but we only enter a position when a storm is right on top of us. We do not take a future position when it is normal weather. We rely on the principle that the storm has durability and persistence for a period of time of unknown extent. The path you take when riding the storm can be varied so you need to scope out the limits of that price path to ensure you remain with the storm. Those limits describe the broad features of the storm itself to be able to define what is ‘in the storm front’ and what is ‘out of the storm front’.
Meteorologists base their forecasts on gross statistical measures such as pressure, humidity etc. rather than the individual mechanics of the air molecules……and in the same way for the markets we should be looking at gross statistical measures such as volatility, momentum, market structure etc. as opposed to the infinite ways price action can unfold.
To be able to ride the storms you need to be present for those unpredictable rare opportunities. To be in this position you need to defend your capital base at all other times and also be diversified. This means that you need to be very selective when you trade as the random chaos will progressively chip away at your capital.
Randomness means that simply with luck alone some may be profitable and some may not but with the Law of Large numbers and the frictional costs of trading, time will get you in the end. To be a trader you must accept that the markets are not Gaussian and that they possess fat tails. If you do not believe this philosophy then you may as well pack your bags and join a new profession. The fat tails that exist in price distributions occur in any timescale and it is your task to identify when there is the greatest likelihood that fat tails will arise outside of the normal everyday churn.
The way we here at ATS tackle this problem is as follows:
- Identify periods when it is more likely that participant behaviour is coordinated. This will be when market conditions are NOT normal. Use gross statistical tools such as volatility, market structure and momentum to define these zones rather than price action. Look for zones outside normal volatility limits or periods when major news events will trigger a major coordinated move. By avoiding the ‘normal’ churn you will tend to avoid ‘random features’ that have no durability of forecasting potential;
- When you have defined the zone within which participant behaviour is more likely to be coordinated than not, then treat every signal in that zone as valid and take them all. Avoid the propensity to predict as emergent features in these abnormal zones can take many forms. Take every trading signal using a systematic approach to ensure that you do not miss the potential whales;
- Abnormal market conditions are by definition unpredictable and rare events so diversification is your key to increasing trade frequency to lift your trade activity. Rather than chasing local storms, become a storm chaser of the world to bring home the bacon; and
- Strictly manage any downside risk but leave your profit targets open to allow for infinite yield.
Accepting that the market is efficient most of the time does two things to your trading psychology. It forces you away from even caring about a single trade to one of simply caring about the next few thousand trades and ensures for your long term survival that you must seriously reduce your return expectations, leverage appetite and focus on risk management.