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Taking Advantage Of Statistical Based Trading Tactics

|Includes:CurrencyShares Swiss Franc Trust ETF (FXF)

Speculator: Someone who makes an investment or trade based on a premise, thesis, or opinion

Trader: Someone who places a trade based on statistical validation

Before you consider risking your money in a trading account, it might be a good idea to make sure you have a rule based trading plan in place that works in both up and down markets. The advantage of a static, rule based plan is you can gauge the validity of it before risking money in the market. We call the process of testing a trading method in the different environments markets throw at us "statistical validation". Once you have studied the method and seen the performance first hand, you can gauge the probability that the method will produce desirable results into the future.

When we say "environment" we are referring to whether the market traded was in a bull market, a bear market, or a sideways market. The best method is one that works in all environments, but depending on your current strategy you will likely find that some environments are better than others. What works in a market experiencing rising volatility may not work as well in a market seeing falling volatility. It is always easier to gauge the effectiveness of a tactic or method when we have the means to quantify the environment for the time period being measured; for example was it a trending or a counter-trending market?

When asked what makes a great trader, the author of Market Wizards, Jack Schwager, an intelligent, thoughtful man who has interviewed the greatest traders of our time multiple times, answered:

"…great traders are extremely flexible. They can very easily change opinion and go from bullish one moment to bearish the next. So they don't become wedded to a particular position - they change as they see fit".

In other words great traders adjust to changing market conditions - they shift with the market. Identifying market environment, and being able to see when price pattern and direction are shifting, and using that information as a filter is a much overlooked step in many traders analysis. By measuring environment we can also determine if there are better times to trade a method, and/or if there are methods we can trade all the time.

An advantage of being able to accurately quantify the current environment as trending or counter-trending, as bullish, or bearish, or sideways is we can also adjust our method or select a more appropriate tactic for that environment. Or, we can incorporate our measure of environment into the method itself, to determine whether we are a buyer or a seller. This is what we have done with our Risk Tolerance Threshold Ratio. Our RTT Ratio breaks a market down into its current patterns in time and designates those patterns as "up" or "down" to let us know which direction to trade in - see Figure 1 - allowing us to take advantage of the scalable nature of markets rather than vice versa.

Figure 1
. Intraday chart of USDCHF and accompanying RTT Ratio

An advantage the RTT Ratio gives us by identifying the direction of the different scales is we can see at a glance the direction of the tradable patterns compared to having to change chart time frames and try to interpret what you are seeing on each chart. It also eliminates second guessing ourselves which is a serious handicap to all but the most experienced traders.

The tactic behind the ratio is simple: take any 3 successive patterns and employ a method that buys dips, or sell rallies in the same direction as the majority of those 3 patterns. The actual price levels we focus on for buy or sell set-ups in our benchmark trading plan at Trading University are very specific, and based on a tenet of Dow Theory.

In this example in Figure 1 we are trading both the 5 thru 25-day patterns, and the 10 thru 50-day pattern. Therefore we would be buying dips based on the 10 thru 50 day patterns - because the majority - 2 out of 3 -- of these three patterns is bullish -- and selling rallies based on the 10 thru 50-day patterns - because the majority of these three patterns us bullish. We have marked the actual signals our benchmark plan produced on the chart.

Based on the ratio we can say we are in a counter-trending or sideways market where it makes sense to be trading both sides of the market, compared to a trending environment where we would be more inclined to let a profit run.

Not only does the ratio take the guess work out of determining which way to trade, but it gives us a static measure of market environment from any point in time, so that we can capture the statistical data of a method or trading plan in the context of the surrounding market conditions. At the same time it is dynamic framework in a live market which we can use to filter current trade signals. It shifts as the market shifts.

The Advantage of Fractal Based Trading Tools

Many of us hear the term "fractal geometry" and our minds flash-back to secondary school, where we may not have fared so well in geometry or math. Luckily "fractal geometry" is a bit of a misnomer, just as the word "chaos" is. Chaos actually means a higher order, while fractal geometry focuses on the base or most simple component in a system, and studies how that base pattern replicates itself to give the appearance of a more complex pattern; another way of describing this is "scalability". I can tell you from experience that one of the most helpful believes a trader can hold is that a market is fractal in nature in that the sum of the parts - think smaller time frame moves --equal the whole - larger time frame moves -- and those parts are scaled replications of the whole, and of each other. To quote Robert Rhea who wrote The Dow Theory over 80 years ago: "One piece of steel does not make a bridge, but every engineer knows that it is a definite part of the entire structure".

Seeing the "entire structure", or the big picture in trading is important, and understanding that technical analysis - the price pattern on the chart today -- is a reflection of all known underlying fundamental determinants at that time goes a long way in seeing the order in that big picture. A price chart to a trader is like measuring the temperature, or heart-rate of a patient to a doctor.

Only traders are not concerned with changing the cause of price movement, as a doctor is in finding out what is making her patient ill, traders are interested in taking advantage of the effects of that market movement right now.

By measuring those patterns with a uniform framework such as the RTT Ratio we give ourselves an excellent analytic tool that lends itself to statistical validation, and provides a filter for real time signals.

To see Jay Norris highlight trade set-ups and signals in live markets during the London/U.S. overlap go to: Live Market Exercise. Jay is the author of "The Secret to Trading: Risk Tolerance Threshold Theory".

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

Disclosure: I am long UUP.

Stocks: FXF