23 September 2010

Technical Analysis: Intuition, Market Structure and Forex Trading

Forex is the perhaps the punisher of intuition, yet intuition is one of the few weapons one has in the market, like everything in forex, there is a little space to slip through.

In a formalism for search in computer science, one maps a search as a series of interconnected points from a start point, called the start node. The start node itself will tend to have a number of possible moves from it, and this is the case for each child node.

The overall number of branches from each node in the search tree, the enumeration of possibilities, is called the branching factor.

One can simply search each branch until one finds the best solution, or a solution if that is all you want. When one tries to enumerate a future for a currency pair, one is trying to say this is the path through from the start node, its valuation now, to an optimal solution, or at least a range for an optimal solution. That is the target one sets for the pair, one's expectation of how the market will move.

For a typical AI search one has a very simple function to test each node for the desired solution, they have to be simple or else the search becomes beyond the computational capacities of any computer very quickly. But in forex one most certainly does not have such a function, but by using technical analysis one tends to assume one has.

There are so many factors that it becomes impossible to make a prediction on this kind of function. Try predicting a move based on fundamental analysis of an economy, no matter how real time it is, how deep it is and how focused it is in the market (e.g. news).

The problem is those factors are so loosely deterministic on the pair (in the case of news for example, the market may react based on its capacity to react). Technical analysis in essence tries to do the same thing. All those loose factors are still factors, look at it like a series of billiard balls coming at all directions on one billiard ball.

It is like a bias in a coin toss, and like the momentum in the billiard ball from something which gets it eventually in its direction. Except what that direction is, is hard to predict, it is the way patterns can take a number of forms at a given point.

More properly it is like somebody coming in and nudging it. Those nudges are from many small traders and big traders, yet other nudges can overpower that momentum (like EUR/USD at 1.5). That nudge was presumably the disapproval of governments to that valuation, which keyed into computational functions in this market which need trends.

A primary optimization function is to make a trend, that is what all those computer programs are searching for and will give the market at any chance, it's just there is antagonism in those directions.

Its just that kind of primary nudge is rare, it happens in news trading but only for a short while. Technical analysis is in essence all the many nudges one cannot really identify (fundamental analysis is the hope that one can collate all those identifiable little nudges to big manageable nudges, like chunking).

Yet there is something more, because there is sometimes in technical analysis signs of the direction of a  pair (or even a primary nudge) before it happens.

That is probably that global optimization, the force towards the best solution, that seems to drive this market and to an extent the equity market. And that is what programs and many traders converge on, except of course until they get knocked off by another nudge or many nudges, which can be themselves, or events in news, economy etc.

All this is why one can have an intuitive feel for the market yet get crushed by it. But order flow is another great weapon, because it is a set of cyclically repeated nudges. That is, the same kind of behavior tends to happen within the range of each major valuation. This is not unexpected as one expects there is a optimization process working exactly on that range.

I am suggesting again that technical analysis in equities and technical analysis in forex are different. One is partly written, one is more dynamic. There is a static structure to equities from the investors, which does not really exist in forex.

What I mean is, there is an order book, with depth, in equities, in forex there is an ever changing stop hunting target zone added to the optimization mix, but the market makers may structure it, and thus you get repeated patterns (the point of my 1 min trading activities). Bear in mind this is forex: the vast majority lose money and even the big money, which is used to ride through retracements, can get crushed.

But feeling that ebb and flow of structured optimization is the best hope.

With technical analysis in forex what is being analyzed changes, there is no static book. That is partly why depending on technical analysis without intense money management (that is to say handling losses, the acceptance of the changing structure of the market on your relatively static interpretation of that structure, your trading method) can be a disaster, there is a fundamental reason why forex trading carries that very daunting warning.

Without deep pockets, and deep experience the moment one enters the market one has taken away the primary pillars of support that others have.

(updated 7/16/15, 9:17am UTC+1)

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