Wednesday, August 26, 2009

A discussion about the random walk hypothesis

Since I have "random walk" in the title of my blog, I suppose I should post some comments about it. The random walk hypothesis proposes that movements of any financial instrument such as forex or stock prices are completely random and therefore cannot be predicted. I'm in good company when I disagree, since it is quite clear to me that sentiments such as fear and greed, and the herd mentality of the market can and do cause non-random behaviour. My search is for the trading opportunities that these "non efficient" occurrences present.

But now, a trick question - do you agree with my analysis of the following charts?

Is my analysis OK? Perhaps you noted some triangle patterns that I missed, maybe a breakout?

The only problem is that they are selected from a random walk of 2,000 price ticks. That's right - using the Rand() function in Microsoft Excel, I created this spreadsheet today and just pressed F9 (recalculate) until I obtained a pattern I liked!  So what does this tell us? It means that the price movement we see can be close to random but can easily lure us into thinking that it is not.

After years of developing systems, I have come to the conclusion that there is a sweet spot somewhere between the following:-
  1. Looking for large numbers of trades, which yields a statistically more significant backtest. More trades come from shorter timeframe charts and small profits per trade. It's very difficult to obtain enough trades to be comfortable with a backtest on a daily chart.
  2. Looking for nuggets of sentiment amongst the noise. These seem to become more prominent in longer timeframes and larger price movements of at least 100 pips.
So this leads me to zero in on systems with TPs and SLs in the 50 to 500 pip range, on 15 minute to 1 hour chart timeframes. The smaller timeframes and stop values apply better to breakout and support/resistance type systems. The longer timeframes and stop values apply better to trend following systems.

I do think that scalping systems (ie very short timeframe, small profits) are possible, but I have never had any success in finding one. My theory is that some price behaviours and indicator patterns are so universally interpreted the same way that they become a self-fulfilling prophesy. A price might drop briefly, not because it is overbought, but because enough people think that it is overbought.

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