Trading With Albert Einstein

In the past, some 2 years or so ago, I spoke about a young man at a Christmas party.  I had the pleasure to meet him again this past Christmas Eve. Our conversation was interesting for he brought to my attention something I had not thought much about.  Since I have a lot of confidence in my algorithms and how well they work, I gave little thought of explaining to others what they were based upon.   

I truly do not believe that understanding the construction of the algorithms would be of any merit to anyone, but I do understand the curiosity of wanting to know.   Well, he wanted to know and though there was not a lot of talk about it, it brought to mind something else.  Something far more important and I thought I should share it with you.  So, at the end of the day for better or for worse you can thank him for jogging my brain.

Theory Of Relativity

Albert Einstein and his Theory of Relativity; that is what was brought to my mind.  Yes, I know my mind sometimes works in weird ways.  In any case, you may know, Einstein’s theory is broken into 2 general categories, that of general relativity and that of special relativity.  Now, do not freak out because I am not going to attempt to explain either of those to you.  But I am sure you much of the theory relates to time.  That was what popped into my mind, TIME and how important it is, how much of it is misunderstood, how it relates to trading and that I have not said much about it.

So, about time, is it so important in trading?  We know price is the same on every chart, no matter what the time or tick we are working with.  Though that is true, time explains why a lot of things occur on those charts.  There is a concept called “fractals”.  What are fractals?

Fractals

Wikipedia offers this definition:

“In mathematics, a fractal is a subset of a Euclidean space for which the fractal dimension strictly exceeds the topological dimension. Fractals appear the same at different levels, as illustrated in successive magnifications of the Mandelbrot set; because of this, fractals are encountered ubiquitously in nature.”

My easier definition is: Fractals are infinitely complex patterns that are self-similar across different scales. They are created by repeating a simple process over and over in an ongoing feedback loop.  You will see that, in trading, fractals are related to time.

In some ways fractals are similar to Fibonacci whereas they start small and grow, but in different relationships.  In our case of Fractals, we establish those relationships by how we set up the scales, as referred to above, or in our case, time on our charts.  Let us say we are using 3 charts with times of 5M / 15M / 45M or 20M / 1H / 6H, but since the trading day is about 6 hours you could call it 20M / 1H / Day where each succeeding chart is enveloping previous bars into the current bar at a ratio of 3 to 1.  

It might look to you that price is moving differently on each chart, but it is really moving exactly the same.  So, in reality, you could day trade off of the day chart since price is moving the same as if is on the 3 minute chart. It is sometimes difficult to imagine, but the movement we see on the 3 minute chart is the exactly the same on the 1 hour chart or the Day chart.  But we see it first on the shortest chart and there is the rub.

 Though the price is the same on the longer chart they do not play the same role in momentum or cycles. Time absorbs the retraces of the shorter chart and they become less visible on the longer chart.  That offers an opportunity for price to continue without so much notice of when it did not. 

Affects of Time

Time has the effect of smoothing out the charts and the movement of that very same price that is reflected on each chart.  That is the reason swing trading has historically produced better results than day trading.  Longer time offers more stability as it offers fewer occurrences to react to.  As traders we often over react and even over trade.  Longer charts tend to reduce that activity.  This is also why I thought of Einstein and the theory of relativity as we are now talking about the relativity of obvious observation and how it relates time.

Maybe that is why so many concentrate on the shorter charts.  Price, though the same on all charts, captures more attention on the short chart.  It holds a bigger percentage of the data in the bar than it would in a bar 3 times or even 9 times larger than itself.  Thus the movement and the computations of momentum and cycles are quicker.  Remember, though they are faster to accelerate they also are faster to stop or reverse. The longer bars absorb the volatility of the shorter bars.  Remember everything that happens in the shorter bars happens in the other bars as well, but it shows less because of the reduced significance in the larger bars.

So, what do we do with all this information?  First, determine how much risk you are willing accept regardless of the time of the chart.   Then look to the shorter charts of what might be the future movement of price.  If it is true, each succeeding bar will confirm that in time.  Keep in mind that the pattern reflected on the shorter chart may or may not be reflected in time on the longer chart, but if it does, it confirms the move with a bit more certainty. 

We could continue to look for confirmations with larger and larger time periods until we are, in fact, looking back as to what has already happened.  So, obviously, somewhere in this process we have to set a degree of risk that we are willing to accept in the trade as there is no absolute certainty.

Time and Exits

Without some reference point to determine an exit, you really cannot compute an exit even when you know your risk tolerance.   But the Stress Free modules will provide reference points to compute exits and these exits will be based on your accepted risk tolerance, a computed volatility or a measured momentum as per your choice. Your chart choice will determine the end results of your trade. 

Fortunately, the TW Trade Manager gives you the ability to see the differences time makes on the screen and how it affects exit points.  One would think that a risk based exit would be the same, but the reference point will be different on longer charts than shorter charts and will produce remarkably different exit points.  Time is what it all hinges on. 

When using the Stress Free trading system, I set entries on the 2 hour chart and exits on the day chart.  Since price is price, it works exceedingly well.  I pick up the sooner appearance of an entry on the 2 hour chart and work with previous closes on the Day chart which is consistent with short chart being filtered of exits that are too quick, and that works because price is still price regardless of time.

There is much more to discuss with time, but (forgive me for this) time being of the essence, I will call and end to this summary review of time.  We could go much further looking at the envelopment process of the bars as it relates to fratals and the overall effect on predicting possible price movements, but that is a subject for another day.

Post Script- I know some of you are Tick chart traders and the relationship of time does not work in the same way as your scale is now the number of Ticks per bar rather than time.

See you on the other side,

Gary Odom

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