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Hi RTs,
Last week, I posted an e-mail titled "Driven Oscillations" and I
received some replies and some questions, mostly privately. I could not
answer them right away because of my computer problems. (I thought that
it was virus. Actually, it was a hardware problem. )
Trading methods should be simple and elegant. Although in that
particular e-mail, I tried to explain it as detail as possible, it is
not a complicated stuff and the conclusion actually is very simple.
Conclusion: use breakout system only when the market turns violent.
Translation: tight congestions in which a breakout occurs suddenly and
violently are usually true breakouts. In this way, we can avoid
catching false breakouts as long as we use breakout rule selectively.
Let me post that e-mail (Driven Oscillations) again (with some
changes). Hopefully, this time, it will not cause any confusion.
Mervin
Old e-mail "Driven Oscillations":
Hi RTs,
The following is the experience I gained from actual trading. I don't
think it is the only approach to solve trading problems. Anyway, it can
be food for thought.
Breakout rule works occasionally but not always. The reason is that it
is being used indiscriminately. Let me explain:
An oscillation is a periodic fluctuation in the value of a physical
quantity above and below some central value. When an oscillating system
is pushed by an external force, we say that the system is driven, and
the resulting motion is a driven oscillation, or driven harmonic
motion. This driven system can be used to describe actual trading
activities. Locals, or day traders, have less risk tolerance than the
medium or long term investors. If the long term investors start to push
the price into one direction (up or down), the locals cannot fight
against it because of the difference in risk tolerance. So, in a small
scale, the activities of locals and day traders can be described by a
free oscillating system. And the long term investors' action is
considered as an external force due to their large risk tolerance.
Hence, the original oscillating system is no longer free due to this
external force. It becomes a forced oscillating system. (i.e. a driven
oscillation) The risk tolerance of the locals can be considered as
"natural frequency" and the risk tolerance of the investors can be
described as "driven frequency". As we know in physics, resonance
occurs when these 2 frequencies are equal to each other. (a relatively
rare event) Let's consider Mexico in Dec. 1994:
http://www.oara.org/mpc/fma/fmarev4.htm
"In fact, Mexico is an excellent example of how FMH works in the real
world: Long term investors left that market, in part, because they lost
faith in fundamental political data. This left only the technical market
data which is stochastic and highly volatile--especially in the
supercharged atmosphere of a political/economic crisis. Investors who
dismiss the importance of fundamental data can only justify their bias
by saying, for a trader, the information is not very useful (unless the
quality of that data causes many more investors to join the trading
frenzy). On the other hand, when a trader experiences a 6 sigma event
which will cause insolvency in a few hours, they are grateful when an
investor steps up and buys because the price change represented only a
.15 sigma event to them. "
The crisis occurred in the moment when long term investors change their
risk tolerance (driven frequency) to that of the locals (natural
frequency). Before, a certain price movement represents a 6 sigma event
to a local but only a 0.15 sigma to long term investors. Now, the same
price movement represents a 6 sigma event to BOTH locals and long term
investors because investors change their risk tolerance to the same
level as the locals due to fear and uncertainty. At this moment, no
long term investor is willing to step up and buy (or sell) and the
locals have no way out. Panics started and resonance occurred. The
market becomes a one-way street.
Anyone who has a course in either Physics or Differential Equations will
know the resonance curve of the system. The amplitude at resonance is
much much higher than the normal value. As time goes on, the amplitude
increases with time t and oscillations will become infinite. Of course,
this exciting phenomenon cannot occur because the system will break
down. The liquidity disappears and market drops like a rock. (or shoots
up like a rocket....IMM Yen in Oct. 7 1998) I call this a gamma trend.
Breakout rule should be used ONLY in this type of situation.
(resonance) Resonance is not often but it is not as rare as what the
normal distribution would suggest. In other non-resonance situation,
buy breaks in an uptrend and sell rallies in a downtrend is a better way
to go, I think. In resonance situation, goes with breakouts.
My mistake was using breakout rule regardless of situation. I paid my
tuition and re-contructed my system. Under resonance condition, it
works in both stocks and commodities. Under non-resonance condition, it
works in commodities but not in stocks. I don't know why. So, I
started to ask RTs about the difference between stocks & commodities'
technical behavior.
All the best!
Mervin
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