- Posted by DynamicHedge
- on October 2nd, 2012
We use all types of techniques to try and understand market behavior. We like to draw trend lines and plot moving averages as a way to quantify difficult to model data. Expected and historical volatility act as a guidepost for what should be considered normal. Even the boundaries of our graphs serve as the unofficial edge-of-the-earth. The end of the page draws its own conclusions about the relative potential of a particular instrument.
We seek out patterns to help explain and categorize what we are seeing. We use these categories to draw conclusions about underlying conditions and future prospects. We need something meaningful enough to create the conviction required to put money to work in an idea. The problem is that some of these patterns and categories are simply figments of our imagination.
An archetype is an original pattern from which all others are based. It is universally understood.
My trading partner and I have been doing some deep research into pattern recognition algorithms and applying them to financial markets with great results. Over the last year we’ve refined the method of extracting important patterns from noisy data. After living with this data we’ve really learned about what it means to find something that is actionable and quantifiable; not just something that looked good. An archetype in financial markets has to be something with the right balance of uniqueness and repeatability. You’ve got to be able to identify it and have some degree of certainty that it will repeat, otherwise it’s not real, it’s just a figment of your imagination.
The graphs below represent the closest thing we can come to truth in patterns. They are the output of our pattern recognition algorithms using data from liquid instruments most closely related to modern market conditions. These are the familiar lines that the market traces out day after day in a manner that appears intelligent on all time frames. We found four of them that occur with striking regularity. I’ve presented the positive version of these, but each of them also has it’s corresponding inverse (meaning there are really 8 variations of 4 archetypes).
Study the lines and think about the human behavior and emotions embedded in them. How many days have you seen the market follow one of these paths, and for what reason? What does the relative degree of frequency that each individual pattern occurs mean for your trading?
This is the tip of the iceberg. Lots more to come.
Disclaimer: Nothing on this site should ever be considered to be advice, research or an invitation to buy or sell any securities, please click here for a full disclaimer.
DynamicHedge is an equities, futures and derivatives trader based on the West Coast. He runs a long/short opportunistic relative-value strategy within a proprietary trading group. More
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