When your trading system is no longer working, you either abandon your system and use a different one, or you tweak it so it works the way you want it to. The large financial institutions follow the same principle. I was impressed to find out that central bankers do the same thing with their macroeconomic models. They’ve figured out that their models — they call them dynamic stochastic general equilibrium models — no longer reflect the reality of the financial markets. So what do they do? They work on fixing them to better recognize shocks or anomalies that cause market crashes. How do they do that? They add more variables into their already complex equations.
Our trading models are far simpler, even though they still contain words such as stochastic and equilibrium in their nomenclature. And we are the only decision makers when it comes time to fix them.
From that point of view, we clearly have an advantage. There’s no need to go through all the red tape and complex communication channels. We are limited to the data that is available to us — typically price, volume, and time, with variables such as volatility thrown into the mix.
With these limited variables, we are able to create hundreds of indicators and trading systems, giving us the ability to determine when buying or selling activity is gaining momentum, when it is slowing down, and when it is in equilibrium.
Over time, you will be able to understand the relationships between these variables and identify unusual activity going on the market. Are prices going up too fast? Is there unusual selling activity for no obvious reason? Are prices overbought or oversold or is it business as usual?
No model will work perfectly, especially given that what is happening today may have no relationship to what will happen tomorrow. And therein lies the challenge. There will always be some surprise element in the market; that’s the nature of the game. Always expect the worst and try to understand the relationships between the variables that you use to analyze the markets. Only then will you be able to recognize those subtle signs that tell you that market anomalies may be close.
Jayanthi Gopalakrishnan, Editor