Observing the markets: Bumblebee is born

I am developing a trading system from the ground up. It’s called Bumblebee. We’re gonna start with the first phase, which includes three parts. Observe market behavior, Code a plan that exploits market behavior, Test the code’s integrity. For acronym fans, this is the OCT phase. Below we will deal with Observation.

The beginning is important because it involves the logic behind the system. Repeatable patterns can be found in markets, but to trade these patterns, I hold the view that there needs to be an identifiable reason for why the pattern develops. It centers around market behavior and the fact that market participants are human and usually act as humans do. This is in contradiction to Efficient Market theory that suggests that market participants always make rational decisions based on their own self-interest and that information is instantaneously absorbed and priced in. When we observe market behavior, we realize how irrational markets really are. But irrational behavior does not mean unpredictable. An alcoholic acts irrationally when he gets lit up and decides to drive to the liquor store to get more booze. But its a pretty good bet (and predictable) that if an alcoholic has a drink, number two through six is not far behind.

Oftentimes, market behavior is exhibited in technical indicators and price chart patterns. Certain candlestick patterns are visual representations of markets revealing themselves. Moving averages represent a group consensus of value. These are all valid hooks to hang your trading hat on. But you can overdo it and end up in a Poisson Distribution before you know it.

For example, consider the following trade system. When the 14-period RSI crosses above 50 and the Ulcer Index reaches 23, and the (insert fibonacci number here) period moving average is (insert another fibonacci number here) percent of price (insert a third fibonacci number here) bars ago, then enter long. That’s not explaining or exploiting market behavior. That looking for patterns. And you can always find patterns in nature that are completely unrelated.

The bottom line is that there needs to be a logical explanation for why a pattern has developed and how it reveals market behavior.

The Bumblebee System is going to trade off the observations that trends, once they develop, continue in their direction until their momentum has become exhausted. Market participants follow market leaders and as the market leaders gather more followers, the trend continues until there is nobody left to follow. The market then sits around twiddling its thumbs until another leader either takes them higher or lower. The trend is your friend until the end, or something like that.

We are going to use two moving averages to document market consensus of fair value. A fast one will demonstrate a short term notion of value and a slow average will reveal the longer term notion of value. The fast one leads the way, the slow one follows. It’s your plain vanilla dual moving crossover system. Long when fast is above slow, short when fast is below slow. But to make it more interesting, we’re going to add a Bollinger band around the slow average. Why? To avoid whipsaws and to give market participants enough time to make up their minds. We ask the market, ‘Which way are you going?’. And then (by inserting Bollinger bands) we ask it “Are you sure?”. If it answers up and yes I’m sure, we go long.

A Bollinger band consists of two lines wrapped around a moving average. The lines are equidistant on the top and bottom, and their distance is defined by a factor of standard deviations. For example, we can select a 2 standard deviation width to the band and capture much of price action. Not 95% of price action as the standard deviation number suggests, but a lot. We are selecting a much smaller factor, something less than 1. We’re trying to keep our question simple in saying “Are you sure?” and we’re not trying to be annoying and ask “Are you absolutely, positively sure?”.

If you draw a moving average and wrap two lines around it, you essentially have four lanes. Two lanes inside the bands on either side of the moving average, and two lanes outside the bands, one over the top line and one below the bottom line. Usually a dual moving average system triggers when the fast crosses the slow. We’re going to require it to not only cross the slow, but its upper or lower band. Once the fast average crosses the slow average and its upper band, it now resides in the top lane and the signal is triggered to enter long. We have a higher threshold for entry. To exit the long, we wait for the fast average to dip below the slow average and enter into the third lane. Short trades will be taken with the same logic in the opposite direction.

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