While the idea of different dimensions in time and space in our physical world makes my head spin, the idea of different time dimensions in markets makes perfect sense. Before however we cover how to identify the appropriate dimension in time to be trading - hint: "the now" - think about this question: "If you only see what you know, how do you ever see anything new"? I ask that question as a polite way of reminding us all that we have the ingrained habit of seeing and hearing what we want to see and hear.
How to determine if a pattern is bullish or bearish
The most important market measure is how to definitively identify a pattern as bullish or bearish. Once you know this simple procedure you can easily identify which dimension or pattern is bullish and which bearish. Before we show you that price point which delineates a bullish pattern from a bearish pattern let's identify what we refer to as the Five Tradable Patterns.
U.S. Dollar Index RTT Ratio
D - Secondary Up
50- Day Pattern Up
25- Day Pattern Up
10- Day Pattern Up
5 -Day Pattern Up
Figure 1 Risk Tolerance Threshold Ratio
This ratio serves as a directional barometer and identifies the current pattern of the most influential trading time frames. It is also a reflection of the underlying economic fundamentals for that market. For this article the ratio's purpose is to provide a visual of the different dimensions in time we are referring to, and to show you that each can be measured as either up or down.
The one trait that Elliot Wave, Dow Theory, and the teachings of Gann have in common - which paradoxically is talked about the least -- is that price tipping point where a bull spills into a bear or a bear morphs into a bull. For Elliot Wave it's just beyond .618, for Dow Theory 66% and Gann .625. Market statistics absolutely show us that over any time frame, regardless of volume, markets routinely bend - retrace - approximately 60% to 65% of the previous impulse move before recovering and resuming that dominant direction. If price does not recover however and holds beyond those levels, then a shift has occurred and the pattern is re-labeled accordingly. This predictable characteristic is used to determine the direction of a market on any time frame. The ratio in Figure 1 represents the current direction of the patterns on those influential time frames based on the height or depth of the current retracement of the last impulse move. The ratio works because it uses market generated information only.
We can then use this information to make trading decisions on the lower time frames, which is what we did in Figure 2. .
(click to enlarge)Figure 2. Intraday retracement in-line with the majority of tradable patterns
We took a Dollar Index intraday chart from this morning and waited for a bearish retracement to provide a buying opportunity in-line with the majority of patterns in our RTT Ratio. To give us an approximate target to set an alert at - so we don't have to sit and stare at the screen all morning -- we marked the .625 retracement level created by the London session low and the U.S. session high at that time.
When markets retrace beyond 50% of the previous impulse move, market participants holding positions in-line with that impulse move start to get nervous. When price moves beyond a 60% retracement, every tick, or pip, brings position holders closer and closer to their risk tolerance threshold. When price moves to a 62% and then 64% retracement it is generally enough of an adverse move to shake the majority of traders out of their positions. As traders who were positioned correctly but who could not afford the risk of further losses capitulate, market makers stop up and buy or sell at these advantageous levels. These repetitive patterns also serve as natural balancing mechanism for markets.
While this is incredibly helpful information to traders and investors it will still fall short of offsetting the many reasons most market participants lose.
Why you still lose
The biggest mistake traders make is trying to predict where the market is going to go next and then underestimating their risk tolerance. Our minds try to cheat by convincing us we can somehow predict the future, while our wallets prompt us to exit trades at the most inopportune times. We completely overlook that we have the power to identify exactly what is happening right now in the market - which is priceless information because statistically we know that current behavior is more likely to continue rather than change. That point bears repeating: "statistically we know that current behavior is more likely to continue rather than change". This is true of people and markets. But rather than position ourselves to take advantage of current conditions we want to go one step further and know - predict -- when change will come and somehow position ourselves to take advantage of that. No doubt change will come, but we can better insulate ourselves from any short-term drawdown this may cause by making hay now, while the sun is shining. And by having a simple method in place to measure the direction on any time frame, we have, by default, a tool to tell us when change is actually occurring.
The second biggest mistake traders make is believing that markets will follow the script they have in their head.
Entropy: Our order versus nature's order
It's only in our mind that we think ordered events should occur. In fact what we consider "order" and natures "order" are definitely at odds. And speaking of odds, they are low that the outcome you want to happen, which makes total sense to you, will actually happen compared to the hundreds of other possibilities. While we enjoy thinking that an ordered outcome that we profit from will occur, odds and entropy tell us it is much more likely that a disorderly outcome that we could not predict will occur.
An example of how our thoughts are at odds with how a market moves is demonstrated in a market moving sideways. Most people see a sideways market as being "unbalanced" in that the market cannot make up its "mind". Analysts would use the term "choppy" or "directionless" to describe a range bound market. Technically however a sideways market is seeking balance; entropy is increasing.
Imagine a clean sheet of 8" x 11"paper. Now imagine tearing that paper up into over a hundred pieces and throwing them into the wind. We see that action as moving from order to disorder. In nature however the 8" x 11" sheet of paper was completely unnatural and the act of tearing it up and throwing it into the wind was one that put the paper on a course to eventually restore the material to its natural state. The bits of paper flying haphazardly in the wind can definitely be described as chaotic. But we forget chaos is a higher order. We need to always remember the power of chaos and realize that while man may have created markets as a way to measure the value of goods; those markets are governed less by our own limited laws and more by nature's laws. It is always a good idea to remember how limited our own powers are to that of nature. Accordingly it is a much better idea to use a trading tool that identifies how the market positions itself in direction and time relative to the day's economic news and developments rather than one that relies on our interpretation of that news and economic theory.
The appropriate time frame to trade
The appropriate time frame to trade is the one that yields the lowest risk and highest reward. Set your risk on the lowest time frames and look to manage the trade on the highest time frames.
One of the most powerful realizations a trader can have is that the pattern on the chart is a reflection of underlying fundamental occurrences in the global markets. Therefore you don't need to focus on those occurrences but on how the market itself is interpreting them as bullish or bearish, i.e.: you focus on the current patterns to determine which time frame to trade. This is where the RTT Ratio comes in handy. If you are seeing the majority of patterns pointing in the same direction then take trades in that direction on lower time frame intraday charts, where your risk will be the lowest - in today's markets less than 20 ticks per contract -- yet manage the trade on an hourly, 4-hour, or even Daily Chart, where the reward can be in the hundreds of ticks. When the ratio is showing conflicting direction for the different time frames either don't trade, or trade counter-trend - where both your risk and reward are on the same lower-time frame chart.
Know that markets are scalable, meaning regardless of time or volume the ratios of retracements and extensions remains constant, and that price is a two way mechanism where what happens on the lower time frames gets replicated on the higher time frames and vice versa. This all means you can use the same trade management techniques and indicators regardless of which time frame you are managing the trade on. It also means you are allowing the market itself to interpret fundamental news, and manage your trades, rather than relying on your own or another's interpretation.
Jay Norris is a trading instructor at Trading University. To subscribe to Jay's YouTube page go to: Weekly Forex Forecast
Trading involves risk of loss and is not suitable for all investors.
Disclosure: The author is long UUP.
Themes: entropy and trading, entropy and markets, Jay Norris, trading education Stocks: UUP
