Search

Creating an Advantage in Markets Through Bayes Theorem


Defining Advantage An advantage is defined as “a condition or circumstance that puts one in a favorable or superior position.” In market forecasting, I would like to say “a condition or circumstance that gives odds better than a 50%/50% chance to win (equal win/loss per trade), or a greater than 50%/50% chance at a net gain in profits“. From a technical standpoint, I have found that this is best achieved by combining two mutually exclusive market timing events that are related to price.

Gaining Advantage The two technical events that I like to combine is the market tape with a market cycle. Therefore I define Market Technical Advantage as ADVANTAGE = TAPE X CYCLE. There is a phrase in trading known as “don’t fight the tape”. The market tape represents evidence of what is happening. This tape may be a classic momentum indicator such as the MACD or in the case of the S&P 500 the Fed Juice. The cycle represents a pre-determined repeating tendency of the past. A good cycle to use for markets is the Solar Cycle. The reason it is important to combine the two is that they are independent phenomena that relate to a common event.

Bayes Theorem

In probability and statistics, there is a theorem called Bayes Theorem. It describes the probability of an event when one knows prior conditions that are/ may be related to the event. In the charts, we are combining the cycle (initial probability) with the tape (prior knowledge of conditions related). This concept of combining the tape with the cycle is a rough application of Bayes theorem.


Real-Life Examples

Here is an example. Every day at 6:00 AM Pete walks his dog. Over the past year, he does this 80% of the time (cycle). This habit is an example of a cycle. Now let talk about Pete’s health (tape). Pete’s health represents the tape or evidence. If we know that Pete has the flu with a fever of 103F then now we now have more information. So if Pete is sick there is a very small chance he will walk the dog. Now if we go back to our cycle at 6:00 AM there is a very small chance that he will walk the dog. What seems like such a sure bet can drop to almost 0% if his health is compromised. He may not walk the dog for a week. So we want to make sure that Pete is healthy first. Then we will know that there is a much higher chance that he will walk the dog. Now we have an advantage. So if we have a cycle of the market that predicts a higher movement of price then we want to make sure that the market is healthy and acting consistently in that upwards direction.


Here is another example. Sally goes for a run at 5:00 AM only 50% of the time (cycle). It is not predictable when she will show up for a run. Some days she runs and some days she doesn’t run. There is no way to predict when she will be out for a run by observation. However, later we find out that she has a variable work schedule. She works an equal number of shifts in the day and in the night. When she works at night she is tired and has less of a chance to wake up early to do her workout at 5:00 AM. When she works during the day she is rested and has more of a chance to wake up early to do her workout at 5:00 AM. When we combine the two together we see that when she works late at night she only has a 25% chance of waking up for the 5:00 AM run. When she works during the day and is rested we discover that she has a 75% chance of waking up for the run. So by combining these two events we now have the advantage to predict what days she will run and the chances that she will run on those days.

Considerations

There are some things to consider here when combining events. I do not combine two trending price indicators together. They can actually be just saying the same thing. In fact, most price indicators on a chart are just saying the same thing in a different way. There can be too much overlap. For example, if I use the MACD and RSI Momentum then these two may just rise and fall together. There is no point to place them in agreement. They are not independent. Second, both the tape and the cycle must be optimized as stand-alone systems in their own regard. In other words, they should each make money on their own. This serves to maximize the chances of them working in combination. Third, the Cycle and the Tape cannot “see” each other. In other words, they cannot be optimized together in tandem even if each gives separate results of greater than 50% during that optimization. Finally, some people try and combine fundamental analysis with technical analysis as two independent events. The problem with this is that fundamental analysis can often become skewed with the Fed. For example, bad news may become good news because the Fed may cut rates to stimulate markets. So it’s really tough to get an accurate gauge of how market will react from a fundamental standpoint in today’s economic conditions.


In the next article, I will give chart examples of combining the cycle and the tape to gain an advantage.




68 views

©2020 by Wolf Trader Futures. Proudly created with Wix.com