Friday, February 16, 2018

Lessons in Trading and Psychology - 5: Cycles

Many times, traders become frustrated and fall into a negative psychology because they are looking for one thing, while the market is doing something else.  In that sense, frustration gives us information: that we are possibly out of sync with what we are trading.

Above we see the S&P futures (blue line) plotted from February 12th through Friday's close (February 16th).  If we were to create a regression line to best fit this action, we would see a line with a decent fit and a positive slope.  That tells us there is a trend component to how the market is trading over that time horizon.

Notice, however, the trend is far from a smooth upward line.  The red line captures a dominant cycle within the trend, where a 50-bar rate of change is expressed in standard deviation units (left axis).  Each bar captures movement in event time, not chronological time.  In this chart, each bar is drawn when the futures have changed price 500 times.  

The event time bars adjust our time series for the volatility of the market's price action.  When we have low volatility, we draw fewer bars and vice versa.  Standardizing the market view this way provides us with a more stable time series, and that helps us better assess cycles within the market.  Those cycles tell us when we are relatively overbought or oversold.

In an upward trend, buying the market when we approach a 2 standard deviation cycle trough ends up providing pretty good entry.  Indeed, we can define a trend by the presence of cycle troughs/peaks at successively higher/lower price levels.  Notice also how the frequency of the dominant cycle gives us a window on how "choppy" the market may be--and how changes in the frequency give us a clue as to whether a trend is waxing or waning.

Stocks or instruments displaying greater clarity/consistency of trends and cycles might be the best trading vehicles for a trader.

Looking at price behavior in new ways opens new trading possibilities--and that can expand our psychology, fueling our understanding and sense of mastery.

Further Reading: