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The Science Behind The Signal: Markets & The 2nd Law Of Thermodynamics

|Includes: CurrencyShares Euro Trust ETF (FXE)

Let's consider the possibility that markets follow the 2nd Law of Thermodynamics which states that the entropy of a closed system never decreases because a closed system tends toward maximum entropy, or equilibrium. Entropy is defined as uncertainty. Uncertainty in the market means low participation rates which mean less volume and less volatility resulting in what traders refer to as a counter-trending environment.

While markets are definitely not closed systems they behave like they are when there is no new incoming information. This means that without new actionable information to motivate participants to trade that market will move toward a balanced or counter-trending state with short, intermediate, and long-term patterns balancing themselves out. This is why markets spend over 75% of time counter-trending. When a market has reached maximum entropy it is so balanced that traders have very little conviction of future direction and take no action until new incoming information - news - unbalances the patterns and volume and volatility - price movement -- resumes.

Equivalently, SLoT, the second law of thermodynamics, means that perpetual motion machines without an external source of energy are impossible, because systems tend toward equilibrium which means indecision or rest. For markets the source of energy is news. News creates motion - imbalance - or a decrease in entropy. But entropy does not decrease for long historically. Trends end.

A market can either go up or down. Another way of saying this for us is a market can only retrace its current pattern - move counter-trend - which would be an increase in entropy; or, extend the current pattern, and or balance the next higher time frame pattern -- trending behavior -- which would be a decrease in entropy. The current Daily chart of the EURUSD in Figure 1 typifies this behavior.

Figure 1. Current Patterns in EURUSD

We have marked out 3 patterns on the chart - the short, intermediate, and long-term time frames. And we have marked the 50% level of each pattern with a purple horizontal line. We will view those 50% levels as "balance lines" and consider that markets spend so much time moving sideways because they naturally tend toward balance.

On January 10th a lower than expected U.S. unemployment report drove EURUSD prices higher to the 50% retracement level of that current short-term pattern to effectively balance the market. Then during the following week successively bullish economic news - a U.S. budget deal, and better than expected U.S. Retail sales and manufacturing numbers -- extended the short-term pattern lower and started to tip the intermediate-term pattern to bearish. Should that intermediate-term pattern shift bearish however it would mean the long-term pattern comes into balance. The constant is the market's tendency to seek balance. It can do this through either decreasing entropy - rising volatility - or increasing entropy - falling volatility.

With the patterns positioned as they are now - Figure1 --bullish Euro news would at best only balance the bearish short-term pattern and prevent a bearish shift in the intermediate-term pattern. While bearish Euro news - positive U.S. economic data --would extend the bearish short-term pattern and shift the intermediate-term pattern to bearish, yet balance the long-term pattern.

What about the effect of no news on the market? Today, Monday, 1/20/2014 is a great day to answer that because it is a U.S. bank holiday.

Figure 2. Entropy on the Hourly EURUSD Chart for 1/20/2014

In the chart in Figure 2 we've taken a 60-minute chart of the EURUSD and broken it down into two patterns and placed the 50% lines. We can see that with no news coming into the market - effectively making a normally dynamic system into a closed system-- entropy, i.e.: balance, sets in right away as price migrates to that 50% level of the shorter time frame pattern. You might ask, "Why did the Euro rise this morning?". A broker might scan the wire hoping to see anything to connect the dots, while an honest analyst would shrug and say "who knows", but not many would guess that the market went up "because there was no news". Have you ever heard the old saying: don't get caught short in a quiet market? It's just entropy.

To make the determination of whether a market is balancing or extending its pattern(s) we need a system in place to measure those patterns. In our next article in our series The Science Behind the Signals we will cover how market patterns are scalable in nature to an eye popping degree.

What is most interesting about the market tendency to balance itself is that it carries price just close enough to where trend traders and speculators have positioned their stop loss orders. And that proves just too much of a temptation for professional market makers who are far less interested in market direction, and far more sensitive to daily profits and losses than speculators. We call that temptation Risk Tolerance Threshold Theory and it accounts for the uncanny ability for people to place there stop loss orders at the exact worst place, allowing market makers to harvest them on a regular basis. But that too is another article.

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".

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Disclosure: The author is long UUP.