Article / 05 January 2017 at 14:00 GMT

How to trade unknown events

Hypothesis Testing
United Kingdom
  • There are a number of strategies available to accommodate market movements
  • But what is available when there isn't any real-time data to work from?
  • For example, there is nothing in past charts to allow for Trump's election
  • Knowing ways to measure the unknown is useful

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Working blind. Knowing how to measure unknown events is a useful strategy. Photo: iStock

By fxtime*

A simple measure for all traders fresh from their New Year revelries is to apply a measure of slippage to market movements to accommodate any – shall we say wilder moves – so often evident at this time. 

This can be simply extending your daily Bollinger bands fractionally outwards to say 2.2 standard deviation settings to lower the chance of entering a trade pre-emptively and suffering excess drawdowns. Alternatively we have the classic probability cone applied to end-of-day values to help hone our positional trade openings and subsequent trade management.

chart
Source: FXTime using SaxoTrader charting

The above strategies have their merits but perhaps we need to be more defined with our trading strategies and start the year on a frequentist footing. Bayes' theorem is a probability theory that seeks an action that will display the most likely outcome/result. It tries to rationalise any data into a confidence value for you to determine which trade action you may want to take. 

Laplace truly developed Bayes' work and formulated a more frequentist approach using prior available data and developed the highest probability for any event. Thus we have the two core statistical models available. One is theoretical probability and the other is frequency probability. 

Both areas have been covered throughout 2016 but what of the here and now. We are in 2017 and about to have a new president inaugurated. We have no evidence in our past charts for such an impetuous character but we have economic theorem to guide us for medium-term modelling. Not a great use for intraday traders though.

Let's consider Kuhn and his applied predictive analysis (feel free to Google this subject). This article does not relate to his forest analogies, however. Kuhn correctly surmised that real-time events can be plotted as a standard deviation pattern often described by myself over the last 12 months, the basic description is found on this link

However, in real time we rely on our own knowledge of market sensitivity to data releases and timings of the day and naturally correlate our past knowledge to market pricing that is occurring before us. Should something out of the normal expectation occur then we would react and make a trade according to our past experience/knowledge and the real-time price event occurring.

kkk  Amazon uses Kuhn's predictive modelling analysis in its business models. Photo: iStock

Typically a price breakout is enough to trigger a trade. Perhaps the greatest exponent of Kuhn was Amazon. It monitored what was bought by its customers and rapidly accrued data showing what was popular and adjusted its supply/demand business models accordingly. But Amazon quickly realised another type of data was appearing. 

Typically its customers would show a history of preferences for searching other products at the same time and for an age-group preference. Price not only was a determinant of what was and was not bought but a tolerance to price became apparent. If a £100 product was bought then an 8% tolerance in price historically appeared in the UK, for example whereby buyers happily paid £92 or £108 for what was intrinsically the same product. However, after that customers sought a far larger market place and price move. The general markets are no different.

Another aspect of Amazon data was the correlation of buyers' preference to buy one thing and also entirely different items too – once again we saw traits by age and price tolerance. This all seems obvious but ask yourself do you trade the markets in the same manner? When you open a trade do you correlate to another market or future?

Typically we can happily trade commodities such as oil as an outright future but we could reduce our risk structure(s) by buying the physical stock, which isn't as reactive in percentage terms as the outright futures pricing. Likewise taking advantage of far-dated contracts that are relatively illiquid as a spread trade on spot price can be advantageous in contango events providing you set your trade strategy correctly.

But what of price tolerance? If the market does indeed have a tolerance to price movement exactly what is it? We all know Fibonacci values and retrace levels and these are in effect tolerance retrace areas that imply regions of potential price entry points but can we tighten these functions further? Regression models are really key here but as 99% of readers have no access to these on their charting platforms let's adapt that theory to tolerance.

When you celebrated the festive period no doubt you imbued a few beverages and perhaps ate more than usual. You would have been drinking and eating within your body tolerances, albeit at the extreme end of physical capabilities. 

But outlier events can occur and when they do they have big repercussions and effects on your body. Too much alcohol has an obvious effect as you become drunk, too much food makes you fall asleep so the body can try and digest the excess food. Thus we need to find in the market where tolerance becomes a big shift within the marketplace. Volume is a useful marker to use, as a price breakout supported with increased volume is indicative of such a move but again not everyone has access to volume charts so let's stick with price.

chart
Source: FXTime using SaxoTrader charting

Now please remember I am only using price as a measure for predictive purposes here. Also I am presenting a binary trade, in other words I am either right or wrong, there is no grey area for these trade set-ups. 

If the trade is correct, you earn. If I am wrong then you will know when to turn the trade and then earn. The trade scenario is not optimised nor "curve to fit" so basically you know your risk and reward. Finally if you kindly have the patience to read to the end there is also the probability of success. Those who want to Google the detailed description and breakdown should search for "parametric proportional hazards models" and read the "time risk" and "risk difference" areas.

So let's look at the chart above. We can see a good strong move and of course a retrace and now we need to consider what we should do. If you caught the breakout you would be seeing your profits rapidly eroding, so do you let it run and hope that the market will recover but potentially take a loss? 

You could cashier your trade now and take a minor profit knowing you might miss a winning trade that could earn a large profit or place a tight stop with its own inherent risks. This is a classic von Neumann dilemma and a version of the classic prisoners' dilemma theory. Had you missed the move then you are presented with similar dilemmas: should you jump aboard the move and await a recovery or trade in the direction of the retrace? We all experience these stress points. Ignoring your tolerance to risk, let's look at the charts for market price tolerance.

chart
 Source: FXTime using SaxoTrader charting

When we get the strong move as shown on the above chart we seek confirmation of a move. If the subsequent candle doesn't make a higher close for bullish impulse moves or lower close for bearish then you know the main momentum move has reached a peak and the market will consolidate or retrace. 

The subsequent candle also gives a tolerance value for want of a better description. Thus in bullish moves like the above we would trade the price breakout to the down side. Note on the chart we didn't get a break to the downside until the yellow candle appears. You only trade price breakouts in this case to the downside and each subsequent candle permits you to adjust your trade orders. 

The chart happens to be daily so it was the fourth candle after the initial move that triggered a short trade but these set-ups work on 4-hour and 1-hour for intraday traders.

chart
Source: FXTime using SaxoTrader charting

Stops are positioned at wave highs (green line) and the first profitable close price, which on the chart has a star placed to show when the trade is halved. 

chart
Source: FXTime using SaxoTrader charting

But what of the probability of success? Can we be reasonable of success? Clearly we see the current moves have worked but can we skew the trade to be far more favourable to us? Let's look at that intraday chart again. EVERY time we get a wave high candle look at the subsequent candle. 

In bullish moves you enter a long trade at the high of the subsequent candle as 87% of the time (five years' data) the market will then move onto to match the wave high at least as a 1:1 matching high value permitting a profit and any further move usually has momentum as trades from other market participants turn around so you can rapidly accrue more profits with a better break-even value.

chart
 Source: FXTime using SaxoTrader charting

The green lines show unfilled orders, too. Often as not it is prudent to leave these orders for anything up to a week.

Finally I will keep posting live updates throughout the week to show how these trades perform.

Happy New Year everyone.

– Edited by Gayle Bryant

fxtime is an alias
3y
fxtime fxtime
Some updates on the Loon (USDCAD)...worked nicely
3y
fxtime fxtime
Also the DAX with commentary on the chart....so far it still applies today.
3y
fxtime fxtime
USDCAD for today....nice profit gained but it appears we are nearing a temporary end of move.Commentary on chart.
3y
John Roberti John Roberti
on USDCAD I went in short at 1,33 an sold at 1,3210 On dax, I went in at 11,560 long and still in waiting for a move...
3y
fxtime fxtime
Nice profit of yours on the usdcad...as for the DAX you are seeing a stalled move at present so trade cautiously mate (currently showing 11572.00 so you are in profit).
3y
fxtime fxtime
Final update on CAD trade.....
3y
fxtime fxtime
FWIW stats suggest a CIT move which should run to approx 20th of this month hence my view we bounce on the spot market. The spanner in the works will no doubt be a Trump-ism that shakes everything.
3y
Michael O'Neill Michael O'Neill
The CAD trade was brilliant and another example of why ALL traders on TradingFloor should study your articles. In fact, Saxo Bank should sponsor a seminar with you as the Instructor.. Win-win :)
3y
fxtime fxtime
LOL...thanks Mike and I highly rate your www.loonieviews.net site which I have now bookmarked :-)
3y
fxtime fxtime
Mike just read your overview on Agility !
https://agilityforex.com/fx-poker-central-bankers-jokers-donald-trump/
It is brilliant but how you have time to do so many analyses and trading is a skillset I need to master :-)
3y
Michael O'Neill Michael O'Neill
Thanks for the kind words, fxtime
3y
zefy zefy
Important article. It very nicely refers to many theories which were described in articles during 2016 and offers new idea/angles to enhance further!
3y
fxtime fxtime
zefy HNY and I can imagine yesterday wa a profitable day for you :-) Some very nice fx moves for us all.
3y
fxtime fxtime
Update on USDCAD suggestion. We have indeed have a potential bounce forming. Had you entered a long when I described the bounce expectation on the short trade close/covering above or at the usual 9pm time stamp (GMT) you will be approx +35 in profit and as NFP is today i would suggest a tight stop.
3y
zefy zefy
HNY to you too fxtime. We welcome all volatility and moves the new year brings to us!
3y
fxtime fxtime
I am fwiw trying to write a tolerance algo for next week that can be manually traded !! Although it would be more suited to a HFT (Qi2) scenario but this one can be slowed substantially down :-)
3y
zefy zefy
I coded function which looks 1min bar move larger than ATR and if subsequent candle contains a tick above/below high/low then entry is triggered. Gonna run tests through NFP today with tight trailing stop setting to see how it behaves :)
3y
zefy zefy
No real money will be harmed in this experiment :)
3y
fxtime fxtime
On fx I use two ATR settings and multiply by a factor eg 1.75 if I am seeking a price breakout strategy or much much smaller if I want a HFT and the stop/controlled entry filters are in two settings also eg close 1 must be equal to or less than close 2 if operating a long only strategy etc etc which next weeks set up will be. Let me know how 1min system performs.
3y
fxtime fxtime
DAX....we may be forming a bull flag !!
3y
zefy zefy
I had a coding error in my function. It only tracked very next bar after large move and did not do anything based on NFP move LOL.
Luckily it is easy to correct :)
3y
fxtime fxtime
LOL
3y
Andrew Perkins Andrew Perkins
Lonnieview bookmark
3y
zefy zefy
Revised 1min version under testing this morning. EURUSD, GBPUSD and DAX earned few pips but FGBL in drawdown. Interesting and will spend more time to fine tune.
3y
fxtime fxtime
You are trading ATR expansion?
3y
zefy zefy
Yes, 1.5 - 1.7 times ATR.
3y
fxtime fxtime
1.7 to 1.75 on DJIA has provided successful for me but 0.45 level for SP500 has proved far more profitable !!
3y
fxtime fxtime
I assume you trading strictly in real trading hours only and not globex?
3y
zefy zefy
Real hours only to have liquidity.
3y
fxtime fxtime
phew :-)

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