Exploiting the edge from historical market patterns. Once again, the comments to recent posts have been most enlightening. The topic for the present post came from a penetrating set of questions asked by NQ Trader in response to my "Wonderland" post. NQ Trader was asking an epistemological question: How do we know that results aren't merely the result of chance?
It seems to me that there are two answers to that question: Such an approach is most commonly seen in the development and testing of mechanical trading system with such software as TradeStation. The definition of edge is thus historically based. True, the future may not mirror the past, and care must be taken to not curve-fit historical tests. Still, the backtesting of patterns over market history has led to significant profits for a variety of quantitative funds. The discretionary trader, by definition, is not relying upon fixed signals for trading decisions.
Instead, he or she is reading market patterns from experience and acting accordingly. The edge of the successful discretionary trader is something akin to the edge of a highly successful athlete: When we analyze a discretionary trader's results, we can see if the trader differs from chance in terms of the proportion of winning trades, the earning of profits, etc.
For a trader who makes, say, trades, we can even conduct simulations and determine the probability that a random series of trades would achieve or exceed that trader's results. Indeed, by treating the discretionary trader as if he or she was a trading system, we can analyze results and identify an edge.
Speaking solely for myself and my own trading, I occupy a space somewhat between these two definitions of edge. I investigate historical patterns in the markets and factor those into my decision making. Ultimately, however, this factoring is discretionary and my decisions to enter and exit trades are made on a discretionary basis as unfolding market conditions dictate.
Let's take an example from the current market: I tend to seek patterns with an edge by asking myself: On Monday, for example, we made an inside day. The day after the inside day, SPY averaged a loss of -. That's notably weaker than the average one-day gain of. What happens, however, when the inside day follows a strong up day as is the recent case?
It turns out that there have been 31 occasions since in which an inside day has followed a daily rise in SPY of over. The next day, SPY has averaged a loss of -. That is quite a negative skew which can be formally established with the use of statistical tests.
When I find patterns such as this--particularly multiple patterns pointing in the same direction--that provides a framework for thinking about the next day's trade. I then wait for the market open and see how the market is trading relative to value, how traders are hitting bids and lifting offers, etc. If I see signs of early weakness--buying that cannot, say, move the market above its overnight highs--I will act upon the historical pattern and try to profit from the edge.
I may feel confident in my reading of the current day's trading patterns, and I may feel confident in the historical pattern I'm leaning on. Ultimately, however, the arbiter of whether or not I possess an edge lies in my trading results. What is the likelihood that those results could have been obtained randomly? That, it seems to me, is the gold standard. If my results are consistent with those achievable by chance, then either I'm trading methods and patterns without an edge or my execution is erasing the edge contained within my methods and patterns.
In other words, we either have a logical problem no edge to our methods or a psychological one inability to capitalize on an existing edge.
In the end, edge boils down to non-randomness , whether we're testing historical patterns or present market performance--and whether we're testing mechanical systems or discretionary traders. Historical Patterns as a Heads Up in Trading. Posted by Brett Steenbarger, Ph. Newer Post Older Post Home. About Me Brett Steenbarger, Ph. As a performance coach for portfolio managers and traders at financial organizations, I am also interested in performance enhancement among traders, drawing upon research from expert performers in various fields.
I took a leave from blogging starting May, due to my role at a global macro hedge fund. Blogging resumed in February, , along with regular posting to Twitter and StockTwits steenbab. I don't offer coaching for individual traders, but welcome questions and comments at steenbab at aol dot com. View my complete profile. Subscribe To Posts Atom. Twitter Trader follow me on Twitter. Are We Past the Bull Peak? Weekly New Highs and Lows: The Stock Market's Rece Big Down Day in the Stock Market: Emotional Resilience in Trading: Emotional Balance in Trading Surface vs.
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