Tuesday, April 20, 2010

How the Market Changes... Adapting Against Market Conditions - Part One

One of the most common and interesting topics of discussion when dealing with expert advisors is definitely market adaptability. If we were able to make a profitable expert advisor then would we be able to make it profitable under every set of market conditions ? Through today's post I will discuss the first part of this fascinating question which is the definition of a "market condition". We will discuss the concept of "market condition" and I will give you my opinion and thoughts around this matter. Through the following paragraphs you will learn more about the origin of the concept, what it generally means and why it is a very gross over simplification of an almost infinitely complex matter.

So what is a market condition ? One of the first things new traders learn is that the market behaves in several "ways". Regular forex education books usually tell traders that there are mainly 3 ways in which the market can move, it can move up, it can move down, or it can move sideways. When I was first taught this question I thought it was simply confusing, misleading and terribly difficult to understand. Doesn't the market need to move up and down to move sideways ? How do you separate these three cases then ? With no mathematically rigid criteria to tell you (a) is moving up (b) is moving down and (c) is moving sideways I felt that the mere definition of the concepts was faulted.

Then further study into this matter led me into the next very popular definition we get, the market can be either trending or ranging. When people say that the market is "trending" they mean that price is moving into an overall direction with significant momentum while the "ranging" concept implies that price does not go anywhere and sustains a medium level of both up and downside momentum which interchanges easily. Again, these concepts have no mathematical basis and they are almost "ethereal" in character.

What is the reality then ? The reality is that price movement is an extremely complex matter which cannot be simply encapsulated into a rigid category. The fact is that there is no way to truly tell which way is which all the time as the market usually goes into periods where there is a "combination" of ranging and trending, sideways and up/down movements which cannot simply be defined as ranging or trending.

So what is a market condition - better defined as a "market state" - then ? Imagine that you could take a photograph of the market at a given moment, that is a market condition. The actual state of the market at any given moment in time is a market condition. Usually the status of the market changes with the evolution of time and these fact leads it into different new conditions which are - by definition - not equal to any other condition seen before.

How in the world are we supposed to develop profitable systems then ? Well, the fact is that we simply cannot distinguish between one market condition and the next in such a way that the system could be profitable under all of them. Systems however, tend to have an ideal market condition under which they are able to gather profits. If we can use a criteria that allows us to make the system look into different conditions and try to fit them as its ideal, then we might have a chance at having a system which is able to succeed even under ever-evolving conditions.

Imagine that the system is a camera and that new market conditions are trees placed at different distances. The adaptability factor is like a lens which allows the system to focus on each new tree that appears and see it as it saw the first tree. Now imagine that we are only looking for apple trees and there is a mixture of peach and apple trees. The lens can focus on all the trees but some of them will be apples and some of them peaches, something which cannot be determined before actually focusing the image. The same thing applies to trading systems with adaptive techniques. The system adapts (focuses) on new market conditions but only some generate profits (those close to the ideal, apples) while others generate loses (those far from the ideal, peaches). The system cannot distinguish between these conditions to filter them before trading them because the system does not know the future, it merely knows that after focusing it sees a tree but the nature of the tree is not known until you see it.

So actually what we do with adaptive techniques is follow the market and focus on present conditions such that an evolution towards a condition close to the ideal would be profitable but we cannot actually know beforehand. Therefore you can make a system that adapts against changes in the market but you cannot eliminate its market exposure, a beautiful conclusion that talks about the fact that all systems go into profit/draw down cycles, regardless of their adaptability.

Tomorrow I will talk about the "lens" we can use with automated trading systems and the evidence I have found that this is a valid criteria to make trading systems adapt to changes in market conditions. If you would like to learn about adaptive techniques and how you too can create simple systems based on sound trading techniques which adapt to changes in market conditions please consider buying my ebook on automated trading or joining Asirikuy to receive all ebook purchase benefits, weekly updates, check the live accounts I am running with several expert advisors and get in the road towards long term success in the forex market using automated trading systems. I hope you enjoyed the article !

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