When driving on a motorway, there's evidence that one lane is used more than the other two. For instance, on a three -
As a car driver, you can take advantage of this ''market distortion'' by driving in an emptier lane and travel faster with less hindrance.
Skewed choice ... busy customers don't choose cashiers at random, but look
for short, fast-moving queues. Photo: iStock
When shopping at a supermarket, customers choose a cashier with the fewest trolleys waiting in the queue. But the savvy shopper further appraises the contents of those trolleys to guess how long it will really take to get through the different check-out lanes. One might also look to see if the customers going through are quick at paying and bagging their goods, or if they are held back by kids demanding sweets or by chatty cashiers.
Unwittingly we measure skew everyday. I could describe the selection of fuel pumps at petrol stations or queueing at airports, banks and so forth. Believe me, we are constantly aware of the effects of skew.
But are we conscious of distortions or bias in the marketplace, and how can we adjust our trades for skew in the markets?
Adjusting for market bias
Ignoring the obvious point of down gaps (covered in this previous article: Skewed thinking
), let's consider a directional skew that is tradeable for intraday traders and can be applicable for weekly tactical traders.
I have covered market directional bias and skew before using a two-day parameter, but now let's look at liquid markets with relatively constant spreads between bid and ask. Our preference is to consistently seek a very easy trade fill. So let's assume we are watching any of the major FX pairings or major indices. Note, however, that I would not use this strategy for equities.
As for time frames, this strategy performs very well on five-minute to daily charts. You can use it for weekly and monthly, but the risk/reward parameters are just too large, in my opinion. Probability of success is maximised on FX markets with 30-minute and hourly charts, unless you are good at programming for five- and 10-minute trading.
But the 15-minute chart is very close in probability of success to the 30-minute/hourly chart. Note the probabilities below:
- 15 minutes equals 82.6% probable
- 30 minutes equals 83.2% probable
- 60 minutes equals 83.8% probable
So the maximum probability of success on major
indices using 30-minute and hourly charts is 84% (an almost equal weighting).
One lane is used more than the other two on a three-lane motorway, which is another instance of the skewed behaviour that is also found in markets. Photo: iStock
A quick look at the Cable (GBPUSD
) chart on an hourly setting (remember you can choose any currency pair you confidently manage). I have highlighted the wave highs and lows that would normally be of interest for price breakout traders and Elliott wave traders.
Source: SaxoTraderGO. Create your own charts with SaxoTraderGO. Click here to learn more.
Look at the likely success of each price breakout. Markets that trade sideways are a nightmare for traders, as there's no momentum to benefit from.
Lagging averages become useless in such periods, likewise classic RSI, MACD or even Bollingers, and so forth, because they all turn horizontal, or flatline, and become useless for real-time trading. So perhaps we should just ignore all these indicators and consider price alone, as that at least shows real-time movement without any lag from preset markers on the charts.
So let's look at the same GBPUSD chart again.
Look at the trade entry points. Daft as it seems, you are buying into resistance and selling into support, because the probabilities above affirm the likelihood that the market will indeed test support or resistance at these levels.
An entry long or short here places you to scalp at the 1:1 wave high or low. The price breakout, if it occurs, means you have a better fill for a move, and the maximum profit rate occurs when stops above and below resistance/support levels are triggered, as this causes an impulse move that you can profit from.
Improvements on this trade structure
You need to find a way of ensuring most of your profits aren't eliminated by dealing costs. If the high/low of the subsequent candle is less than five pips away, then ignore that trade entry.
You can enter on the second subsequent candle too, but not the third, as the odds become as low as 53%, which is akin to tossing a coin.
For FX majors, if the market comes within four pips from a round 100 number, the odds of reaching that round number equal 92.3%. So watch the round numbers for an early entry point for a scalp only. FX majors have a habit of attaining round 100 values then recoiling before returning.
Invariably when we see wave highs or lows, the marketplace has set a constraint on order flows. Such a bias or skew can be manipulated with these orders as you seek to catch any sudden moves or breakouts. But the worst case scenario, like the queue at a supermarket, is that you simply get to the 1:1 wave high or low, but a profit nonetheless.
How can we further improve a scalp trade?
We can trail our trades for maximum accrual of income. But we really need a greater confidence factor to build the trade, either by compounding our trade entries on the subsequent two candles or have confirmation of a minor trend.
So really we need to count our highs and lows up to a maximum of 3.
A strong wave pattern shows a definitive high or low. Subsequently the next wave marker will be just as distinctive. We do not want a plateau pattern, as that is a different trade structure, which is a defined support/resistance level to trade from. Once we have our second defined wave high/low, we look for a third.
Now you have a pattern of confirmed skew. First you can trade from the strategy above, looking for momentum, but wave 4 is the real earner. Wave 4 will show a market bias for the here and now. It will usually pull back slightly, and once the subsequent candle after wave 4 has appeared, trade the break of that in the direction of wave 3 to wave 4.
So if wave 4 occurred from a bullish move, then the subsequent candle will give you a range to trade the upside move. Likewise, the second subsequent candle; a break of that to the upside should be traded if wave 4 was a bullish move. No more than three candles should occur after the wave 4 for a trade entry to trigger. Now your trade probability rises by 1% on the above data set.
However, these trade entries will run on and on 92% of the time, so your trade management becomes easier.
I will post updates on this trade structure, as it is easier to see it work live than to try to describe the nuances in detail without an example.
The important point is to determine from minor price patterns exactly what the bias happens to be and if scalping is rapid with your stop placement. While these trades are profitable, pay attention to the second chart, as that meant less drawdown on your account than with the first chart.
Now look at the third chart, and you will see there was no drawdown, as you took advantage of a confirmed market bias. This is a business where we aim to minimise drawdown and potential losses, and through the progression of these three charts you will see that trades can be enhanced in your favour and into your bank account.
— Edited by Robert Ryan
*fxtime is the alias of an analyst whose expertise is statistical hypothesis testing For more on forex, click here.