So, you are good at technical analysis…. You know all kinds of head and shoulders patterns, triangles, diamonds, Fibonacci confluence zones, butterfly and bat patterns and many, many more… The problem with knowing which ones of them offer best reward/risk ratio is that you need a fairly large sample of live trades to draw any conclusions. Plus today’s technical analysis has less to do with art of drawing lines on chart and is more about traders using advanced tools from fields of physics and statistics.
Smoothing time series
Once you dive into systematic trading, problems of reducing noise and smoothing the time series will arise. So, sooner or later you will stumble upon John Ehlers indicators. He introduced many tools that are now used by traders around the world that help them get the clearest picture of the situation on the chart.
First set of advanced tools to consider are filters. The simplest smoothing filter ever used is a simple moving average. But its usefulness in today’s dynamic markets is very limited. Nowadays markets can move very far very quickly or go sideways for long time. With such an inconsistency of market behavior and big differences between particular markets a trader needs tools that will adapt to the current market regime. All advanced tools, like Kalman filter, T3 Tilson, Ehlers Zero Lag Moving Average are adaptive, meaning that they will be more sensitive in a fast moving market and far less sensitive during sideways moves. But the catch is, that every tool is designed for a specific task, has its advantages and disadvantages, and will behave differently under different market conditions.
So here comes synthetic data, that purposely goes over all market conditions like strong trend, wide or narrow consolidation, cyclical or flat. Plotting different filter onto synthetic chart will help a lot with understanding how they work, and what would be the best application for them.
John Ehlers indicators
After getting acquainted with smoothing price time series we can move onto indicators. Of course, it is possible to use adaptive filters on them, but since most oscillators’ readings are confined between lower and upper boundary our filters will only work in one, cyclical market. That’s why most traders choose Inverse Fisher Transform as a way to smooth oscillators to get the clearest picture of the situation on the chart. The most popular indicator that is used along with Inverse Fisher Transform is RSI. But apart from RSI IFT this smoothing method can be applied onto CCI, MACD and many more. The nicest thing about using i.e. RSI IFT are not very clean buy or sell signals, but the ability to quickly switch trading signals from mean reversion to trend following or the opposite. And this is the “Holy Grail” that most traders strive to find. Not when to buy, sell or cover but what regime is the market currently in.
After briefly talking about John Ehlers indicators that are accessible through Tradestation, Ninja Trader or other popular trading platforms we can finally move to the third, and the last brick of our simplified trading puzzle – volume. There are traders that pretty much build their entire trading systems around market volume. Others would more or less accurately study it to find confirmation for a trading signal but almost nobody will ignore it.
Volume indicators
Interestingly the universe of volume indicators is minimal. One of the most popular volume indicators is David H. Weis Waves. This indicator is based on Zig-Zag indicator that marks price tops and bottoms according to the size predefined by user. If we choose 5% swing as a Zig-Zag input, we will get lines on price chart that will show all swings that are larger than 5%. By only doing this we get nicely marked swings that make reading the chart so much easier.
But let’s go back to volume. Zig-Zag cumulative volume sums up all volume along the swings. This way trader can see if she or he is positioned with or against the predominant market force. Plus it is possible to compare different swings to see if the larger trend is still in force or the reversal is imminent.
Combing all above into a strategy
Good and robust trading system, no matter proprietary or systematic has to be based on price time series. With high probability it can be said, that it also work with volume and indicators. Combining it all into one strategy should make it profitable and robust. It won’t be easy and will require a lots of experience, but it is possible.
