Wednesday, April 21, 2010

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

Yesterday we talked about the definition of a "market condition" and how systems can try to adapt against changes in this conditions my "making themselves ready" for the appearence of an "ideal type" market state. I gave you an explanation based on an analogy with a camera an trees placed at different distances which makes the ability of the camera to focus the systems adaptability and the type of tree the actual result. Today I am going to talk about the "lens" which may allow a trading system to prepare itself for changes in market conditions and the evidence I have found of this actual adaptation technique being simple and valid to adjust our systems to ever-changing markets.

So what does the "lens" actually do ? Imagine that you have a system that trades a very simple entry like a moving average cross with a stop loss value of 50 pips and a take profit value of 50 pips. The perfect setup for the system is when there is a moving average cross and the market moves 50 pips towards the favorable side before moving 50 pips into negative territory. This is what we could call the system's ideal trading condition. However if you analyze any moving average cross for the past 10 years and you determine the mathematical expectancy in terms of pips, you'll notice that the actual movement varies greatly as market conditions change. Sometimes the system would be able to capture 100 pips, other times 20, other times 50. In the end, you find that the "ideal" condition for the system is fairly rare and when it appears it seems that it is failing to achieve its true potential. What we want to do is implement some type of adaptation technique such that those 50 pips do not remain constant but that they change with market conditions such that the probability of reaching an "ideal" condition becomes higher.

But how does the market change ? What makes a moving average cross in 2004 give only 20 pips and in 2008 give 300 ? What fundamental characteristic of the market changes ? Of course, this is not an easy question. An analysis of market properties over time related to the extent of movements reveals that the size of movements such as moving average crosses increases as volatility does. This means that if volatility grows, then the extent of our TP and SL should grow too to show us the "ideal" condition under current market conditions. This is the technique used on many of my trading systems which adapts a system's parameters against changes in market volatility. This allows the systems to remain efficient and fit to the current market's ideal trade while maintaining a very good degree of simplicity.

So the "lens" of a trading system can be market volatility, with this tool systems are able to "focus" on current market conditions and get a clear picture of what an ideal trade under the current market status would be. This adaptation proves to be vital for systems to survive to changes in the instruments they are trading as systems which maintain fixed parameters are like a camera with a fixed focus, once the picture changes they aren't unable to determine what the image actually is.

It would be naive to say that volatility is the only actual parameter of the market that changes with changing market conditions but it is the easiest parameter we can measure that allows us to generate an adaptability criteria. Of course, other ways of adaptation which measure other aspects of the market such as "pattern shapes", "length of trends/consolidations", etc are also possible but their measurement is far more complex and doesn't necessarily generate better results than those that arise from a simple volatility adapting criteria.

If you would like to learn more about adaptability and how you too can learn to build systems which adapt to changes in market conditions using volatility 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 !


cador said...

Hi Daniel,
As usual very, very interesting post. 1.Could you please elaborate a litle bit about the best indicators to deal with volatility?
2. Could ATR (or other indicator...if any other) be coded for all type of EAs? 3. If so, how can we set the best parameters of the indicator for the diferent time frames?
Thanks a lot and God bless you for giving and sharing with us these extraordinary tools and knowledge. Cador

Daniel said...

Hi Cador,

Thank you for your comment and kind words :o) I am definitely lucky to have faithful readers such as yourself. I will now try to answer your questions .

1. This is a difficult questions which has a long and a short answer. The short answer is that the ATR is probably the best, the long answer will be given in another post :o)

2. Yes and no, sure, the ATR can used to adapt any trading system but some experts may benefit from other type of adaptation. It is always good to consider the particular trading systems and then consider the means of adaptability. Not all cameras may use the same lense :o).

3. The best parameters and time frames are known by a mathetmatical expectancy analysis. I made a series of videos in Asirikuy a few weeks ago about this topic and how mathematical expectancy allows you to know both the best time frame and best exits for a given trading system.

Your very welcome :o) I do my best to put up quality material on the blog and I am glad you like it. Stay tuned for some further insights into this topic during the next few weeks. Thanks again for your comment !

Best Regards,

Daniel Fernandez

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