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Jay Norris is a 20-year CBOT floor veteran, author of the Best Seller "The Secret to Trading Forex, Futures, and ETFs: Risk Tolerance Threshold Theory", "Mastering the Currency Market", McGraw-Hill, 2009, and "Mastering Trade Selection and Management", McGraw-Hill,... More
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Trading University
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The Secret to Trading Forex, Futures, and ETF's: Risk Tolerance Threshold
  • Trading In An Asymmetrical World 0 comments
    Dec 29, 2013 1:00 PM | about stocks: FXE

    A market is the measure of the value of what nature provides and man improves on. Therefore to measure market movement we need to accommodate that hybrid nature.

    One of the largest drawbacks for people learning to trade is they rely too much on the computer, a man made tool, for their indicators. The problem with a computer is it is still no match for the human mind - a natural tool --when it comes to the most important aspect of market movement: pattern recognition. (See: Humans Are the World's Best Pattern-Recognition Machines)

    Computers are great at recognizing symmetry while humans are great at recognizing patterns which are semi-symmetrical, i.e.: asymmetrical. The current 4-hour chart of the EURUSD in Figure 1 is a great example of this.

    (click to enlarge)
    Figure 1. 4-hour chart of EURUSD in Nov-Dec 2013

    The green horizontal lines mark the exact same retracement ratio of the preceding impulse up-move. This series of patterns are not symmetrical however because the middle pattern is smaller than the pattern on the left and the right. The retracement level for that middle pattern was drawn from a smaller impulse up-move. This is easier seen in Figure 2 where we've highlighted the individual patterns with a box.

    (click to enlarge)
    Figure 2. 4-hour chart of EURUSD in Nov-Dec 2014 with fractal patterns

    Once we outline the individual patterns we might describe it as two larger patterns connected by a smaller pattern with the patterns being scalable. The computer programmer on the other hand would be thrown off by the size of the patterns. The scale of the individual patterns is stable - symmetrical - but the size is not.

    Fortunately for traders the scalable, yet asymmetrical nature of market patterns does not lend itself to being measured by computer generated technical indicators which are at best secondary, i.e.: lagging indicators, of price itself. The beauty of fractal design is that each new iteration, or pattern, is slightly different than the previous pattern. While the human eye is good at following slight changes due to progression, a computer is not. The computer calculates symmetry, or exactness. In the real world however dynamic systems are far from exact. In a fractal world each new pattern is a slight variation of the previous pattern -- think of the branches and leaves of a tree, or a larva in a cocoon - where after just a handful of iterations that difference will have increased enough to be completely different to the original or programmed pattern. On the other hand our eyes can easily follow the string of slight changes to a pattern over time.

    We use what is called a Risk Tolerance Threshold Ratio (RTT Ratio) to measure the scales of the different patterns in a market to determine which markets to trade and which direction to trade them from - See Figure 3.

    Figure 3. Risk Tolerance Threshold Ratio for Euro

    The ratio defines the direction of the different time frame patterns using a static scale, is scalable itself (like the markets), and provides structure to enter trades at (structure being support or resistance - i.e. the green lines on the charts which are the scales within the patterns). The trader chooses any three successive patterns, and trades in the direction of the majority of those patterns. The premise is that the majority of patterns will always be a reflection of the underlying influences, i.e. significant fundamentals, in that market, therefore we will always be trading with the trend. The RTT ratio is a great tool for keeping opinion and emotions out of our trading decisions, and it provides a simple mathematical framework which we can use to back-test or forward test a given trading method. We can go back in time and measure the patterns in place to see what type of environment that market was in. It is also an excellent tool for benchmarking, or statistically validating the success of a trading plan in both trending and counter-trending environments. While the RTT ratio can be programmed, we recommend keeping it updated by hand. The ratio measures the direction of the patterns based on actual highs and lows as a market progresses through time, rather than try to fit the market to a computer generated indicator.

    Another area of pattern recognition where humans hold an edge is time. Just as each pattern on a stock or currency chart is slightly different in scale and length, they are always different in time also. Trains and planes may run on schedules but markets do not. Sometimes the shift of a 10-day pattern is significant and sometimes it is not. The chart in Figure 4 demonstrates this.

    (click to enlarge)
    Figure 4. 5-day thru 25-day patterns in EURUSD in Dec. 2013

    The majority of short-term patterns are lower as seen in the RTT ratio in the upper left hand corner of this chart, therefore a trader who was automatically following just the 5 thru 25 day patterns would have missed a buying opportunity and possibly lost money on sell signals.

    As traders we need to differentiate when a particular time-frame pattern shift is significant and when it is not, and we will find this easier to do if we understand that when it comes to human interaction "nothing", as the old saying goes, "is carved in stone". Or as the trader Paul Tudor Jones reminds himself of often, "The blade of grass that bends avoids the scythe". If the short-term patterns are telling us to be taking sell signals, but we see longer-term scales (support) is still holding - as in Figure 4 -- and the market is still exhibiting higher lows overall than we disregard the short-term patterns and pan out to the next higher time frames set of patterns, see Figure 5.

    (click to enlarge)
    Figure 5. 10 thru 50- patterns in EURUSD in Dec. 2013

    The chart in Figure 5 is much more intuitive. The RTT Ratio is bullish as the majority of patterns are higher. By using our intuition, and market sense - remember the old adage "don't get caught short in a quiet (think holiday) market" -- and basing our decision on the overall pattern of higher lows on the 4-hour chart from November thru December we can see that the RTT Ratio in the upper left hand corner of Figure 5 provides a better "fit" than the shorter-term ratio in Figure 4. But the biggest tip off came from that green horizontal line on the right side of the chart holding. As long as that line - what we call RTT level or pattern line - held as support we knew to respect that pattern it represents. We can say that RTT level was a controlling influence because it marked the level where that pattern would have tipped from bullish to bearish. As long as that pattern stayed bullish, common sense should have told us to stick with the RTT ratio in Figure 5 over that shorter-term ratio in Figure 4. And we can see from the right side of the chart in Figure 6 what the market did next.

    (click to enlarge)
    Figure 6. EURUSD chart culminating in December "holiday market" rally

    It really is good news that computers are still limited compared to the human brain regarding pattern recognition. If this were not so the largest banks would already have programmed their computers to suck all the money out of the market. As it stands now banks and broker dealers make the vast majority of their trading profits from their market-making operations - which means their primary focus is not on directional trading, such as we demonstrated here, but on taking the other side of as many of the public's trades as they can and locking in a sliver of a profit on each trade.

    The advantage of understanding the scalable nature of markets and applying our own intuitive knowledge is breathtaking. And that path will be expedited for those of us who understand the computer is just a tool and it is still humans who make the key decisions.

    Jay Norris teaches at Trading University and wrote The Secret to Trading: Risk Tolerance Threshold Theory.

    Trading involves risk of loss and is not suitable for all investors!

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Stocks: FXE
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