Monday, June 28, 2010

What Doesn't Change : Talking About Inherent Characteristics of the Market

Perhaps one of the most important questions you can ask yourself when you start using automated trading systems is : how will I survive in the long term ? This is one of the most common inquiries made by traders new to the field since it seems to be evident that the market is an ever-changing beast that does not allow the mechanical exploitation of any inefficiency for too long. New traders often experience this when they first begin to use automated trading systems. Their systems do very well, then fail or they never do well at all. Besides the fact that many of these systems don't have adequate evaluation- leading with inadequate and unrealistic expectations to long term loses - traders almost never ask themselves : what doesn't change ? It is obvious that if you want to exploit a given characteristic of the market for long term profitability you have to look for characteristics of the market that remain constant as a function of time. But are there any ? On today's post I want to share with you my view about market changes and why - even though the market changes- some characteristics of the market remain constant.

When you start to trade the market seems like an invincible beast that behaves in a very unpredictable manner. I remember that the first few months I traded I used to think "I got it" only to discover that the market would rip my strategy apart the next few months. I used to behave erratically - like most new traders behave- modifying my strategy every week in a desperate attempt to "adapt" to changes in market conditions. Of course, my focus at that moment wasn't the understanding of market inefficiencies but the massive multiplication of my money from 500 USD to a few million in a few years.

It wasn't until much later that I decided to stop my journey and build an understanding. If I ever was going to make money from this seemingly chaotic thing, I would need to find the "science" behind it. It became important for me to understand how the market behaved, what changed, what didn't and what strategies could be built that would most likely work for the next 20-40 years. I needed strategies that could work for long enough to build myself a decent income and NOT strategies that would put my capital into excessive risk or work for a year and then wipe my account.
The question becomes : what doesn't change ? After reading a lot of books and watching market behavior for many months, I started to realize that the only thing that doesn't change in the market, is the specie trading it. The market is traded by humans and therefore any aspect of the market imprinted with human behavior should remain fairly constant. As many traders have discovered I started to see that - although individual human behavior is very different - crowd behavior doesn't change very much. I then read a few papers on game theory experiments applied to economics on groups of people across very different cultures and the results started to match up as the groups became bigger. I then realized that - what doesn't change - is simply the way in which crowds react to price action.

How do crowds react to price action ? You see manifestations of this everyday - not only in the form of market trends - but in the form of long term reversal and continuation patterns, support and resistance levels, etc. There are some characteristics of the market that simply do not change, characteristics which have appeared time and time again during the past 30 or 40 years. Evidence of this is present on almost all market instruments from the GBP/USD, to gold, to the DOW index. However you will notice when you do a close analysis that - even though these objects are ever-present within market instruments - their AMPLITUDE and LENGTH changes as time evolves. A trend that may have been only 200 pips long in 2004 can be 1000 pips in 2010 and the reason why this happens is related with the market's trading volume.
As time evolves and there are more people in the world, the amount of money being moved in the markets becomes larger and therefore the extent of inherent characteristics of the market caused by crowd behavior also become larger. Through different market conditions, there may be larger or smaller movements of money, causing overall changes in the extent of market moves that appear like "large changes in market behavior" but that are no more than the same old characteristics viewed under the looking glass of a different volatility. For this reason, the key - I believe- to the exploitation of long term market inefficiencies seems to be the use of an inherent market characteristics that changes only with market volatility. Trends are a perfect example of this fact and there are many examples of successful trend following systems that achieve their long term profitability through adaptive criteria based on market volatility.

If you would like to learn more about automated trading systems and how you can build your own likely long term profitable systems with sound risk and profit targets 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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