Lack of understanding of time and its connection with trends has led to the failure of anticipatory and trending systems.
The only difference between trading and investing is of time. A larger holding period is called investing and a smaller holding period is trading. Shorter holding period reduces the risk in terms of time, if a trader can get in and get out fast, it is assumed to be less risky than staying there. Since large moves take time, a trader uses derivatives to leverage and assume more risk, the same risk he wanted to reduce when he moved from becoming an investor to trader. So the idea is that what really matters is how long you are holding the asset, and what is the leverage you are working with.
There are more of such misconceptions we live with. Fundamentals is the most followed research and news is considered the driver for markets, but the underlying theory that is efficient market hypothesis (EMH) clearly believes that one cannot profit from markets consistently as market movements are random. In other words what the theory says is that trading systems cannot work.
The evidence available
David R Aronson in his book Evidence based Technical Analysis, details the idea of applying the scientific method and statistical inference to trading signals. The author goes about systematically proving the flaws in the random model and illustrates how non-random price action can be profitably traded. He also counters the idea of deviations by highlighting that the positive deviations are as likely as negative deviations and hence have symmetry. Aronson may have made his case of building trading systems in his work now, but trading using systems for a living is a pretty old vocation with a history of marketing techniques.
It doesn’t work
In his book, ‘How I trade for a living’, Gary Smith covers the trading systems comprehensively. Many trading system developers spend all their waking hours trying to curve fit the past into a marketable Holy Grail system. There is a market for such systems where developers turn into marketers and sell between 50 and 75 copies earning upward of $100,000 for a system that works on paper but is short on real money profits.
The drawdown section is a pretty interesting read, where Gary highlights the maximum drawdown (worst loss) statistics. According the Gary nearly all of the commercially sold systems are untradeable due to excessive maximum drawdowns because by nature, all systems are optimised and there is a tendency for most systems to degrade over time from their release date. The book is a shocker for someone who has ever purchased or is planning to purchase trading systems.
Trend following systems are exposed to significant risks. For, example most trend following systems generate unprofitable signals 50-65 per cent of the time. These occur when markets are trendless, which is the case majority of the time. During these times the trend followers experience the dreaded equity drawdown. During drawdowns it is not unusual for successful trend followers to lose up to 30 per cent of their trading capital. Thus they need a strong motive to tolerate drawdown risk. That motive is the opportunity, though not the guarantee, to profit from price trend when they occur. In other words large scale trends provide an opportunity for trend followers who are adequately capitalised and who manage leverage correctly.
Can time triads help?
Such diverse failure is owing to the fact that both trending and anticipatory systems today lack understanding of time and its connection with trend. So if we knew how to avoid a trendless market, we would overcome a significant drawdown on our portfolio and push the industry in a more positive direction. How can time triads do it?
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The idea of time triads or time fractals can be visualised as one triangle, made of three triangles subsequently dividing into nine triangles. Each of the triangles signifies a time cycle. A time cycle is assumed to cause a trend, the rising part of the triangle taking the prices up and vice versa. The simplest way to understand trend is when all the three time frames rise together, a confluence across three time frames viz. monthly, weekly and daily causes an uninterrupted up trend and vice versa. As one can observe that such confluences are fewer and lead to lesser number of trades. Unlike the conventional system that attempts a trade on every leg up and every leg down. A nine triangle could create nine legs up and nine legs down. Whereas the time triad system looking for trends at the same time on three digress would trade only four of these nine trades. The same aspect works on the down side. The number of conventional shorts is nine, while time triads only generate four shorts. This is less than half of the conventional time. The idea is simple and can be used on any time frame, 1-5-10 min charts or on larger time frames.
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Applying it
Back testing should also be easy and with multiple indicators. One could even see it working on the Sensex. A positive buy signal could be generated when all the monthly, weekly and daily closing are positive. This happened the first time at the start of April 2009 as prices moved from 10,803 to 15,603 on 14 June 2009, a rise of 44 per cent.
The idea is not to shoot till all the ducks are in place. This aspect of time triads takes care of the trending part. The some triad structure can also assist in anticipatory model and in subsequent selection and classification of a trade. The major drawback is that time triads could be hard test of patience for someone who is used to aggressive trading and is not used to vacationing. Traders reading this should know that I am divulging an entry trick not an exit strategy. Getting out has always been more important than getting in and not to mention risk management and leverage. Even the best trading system played with disproportionate leverage, poor risk management and large exposure can be suicidal.
The Kelly bet, is a formula used to determine the optimal size of a series of bets. In most gambling scenarios, and some investing scenarios under some simplifying assumptions, the Kelly strategy will do better than any essentially different strategy in the long run. It was described by J. L. Kelly, Jr, in a 1956 issue of the Bell System Technical Journal. In recent years, Kelly has become a part of mainstream investment theory and the claim has been made that well-known successful investors including Warren Buffett and Bill Gross use Kelly’s methods. Simply put, the optimal fraction of a bet depends on the probability of win and the ratio of average win to average loss.
Technical analysis guru, John Magee said, “We can never hope to know why the market behaves as it does, we can only aspire to understand how. History obviously has repetitive tendencies and that’s good enough.” Magee, as we know was talking about time cycles. Just like a human, smart or dumbness of a trading system is linked with time. An exit and entry signal in time is what matters, the rest is noise.
The author is CEO, Orpheus.asia, a global alternative research firm