One of the problems that afflicts traders both new and old is the belief that everything they see occur in the market has an underlying cause and if this underlying cause can be understood then the markets can be mastered. The problem with this approach is that it fails to acknowledge that markets are natural systems and are governed by the mathematics of natural systems – particularly the laws of statistics. Put simply these laws say that a system will have a natural distribution of events and the only driver of these movements is a function of little more than expected volatility.
Looking for a signal within this noise is a futile endeavour.
Consider the chart below of the S&P/ASX200.
You can see that the chart ebbs and flows – it has a range of movement over a certain amount of time. If we were to look closely we could say that price exhibits a certain volatility. That is price moves a certain distance in a given period and price displays the function of autocorrelation or trending. Both of these are functions of any natural system.
On the chart below I have plotted a 15-period ATR – this is a good measure of volatility,
From this chart you can deduce that price has what can be termed a natural rhythm – that is it will move a certain distance of its own accord without reason or external influence. This is simply the nature of distributions. For example, if the index goes up 50 points and the average ATR for that period is 55 points then you can assume that there is no reason for it to move other than it moved. This does seem somewhat circular and is difficult for people to grasp because we have cause and effect embedded into our brains. We assume if something happens then there must be a cause.
We have trouble accepting that statistics means that things can happen without a reason.
A real-world example of this phenomenon would be a lottery agency that has sold more winning tickets than its counterparts. People will look for a reason for this or call the agency lucky when it is simply obeying the laws of statistics. If you get enough agencies selling enough tickets then it is unavoidable that one will sell more than others.
So if you have a never-ending series of price movements such as those that occur in markets it is inevitable that price movements will obey the statistical laws that govern distributions.
This means that searching for a signal within the noise is largely pointless – it may be of emotional comfort but is largely useless in the grander scheme of trading. In fact it may be detrimental to your trading as you become obsessed with noise.
