Trading with Market Statistics VIII. Counter Trend Trades in Symmetric Distributions

[jperl]

In the discussion about VWAP in Part II, we introduced the concept of skew, a measure of how the volume distibution deviates from a symmetric or normal distribution. The sign of the skew allowed a new trader to decide in which direction he/she should look for a trade setup. Positive skew meant look for long trades only. Negative skew meant look for short trades only. We have yet to consider trading aspects in markets with symmetric distributions. Like breakout trades discussed in part VII, trading symmetric distibutions is an advanced concept. Not for newbies to be dabbling in.

A symmetric distribution is one in which the skew is very small or zero

Skew = (VWAP-PVP)/SD ~= 0.

There are a number of implications of this definition as follows:

1)a small skew means the VWAP is close to or equal to the PVP
2)Given a small or zero skew, it means that price action has moved across the VWAP at least once, otherwise the volume distibution could not be symmetric.

Now comes the kicker:
3)If the distribution is to remain symmetric, it must continue to oscillate across the PVP and hence the VWAP.

This implies trades of the following type:

If price moves to the 1st or 2nd SD above the VWAP pull the trigger SHORT.
If price moves to the 1st or 2nd SD below the VWAP pull the trigger LONG

WOW- that's completely opposite to everything you've been told in the last seven threads. Up until now, every trade was taken moving AWAY FROM THE VWAP. Now you have to learn to take trades moving TOWARD THE VWAP.

To trade a symmetric distribution, everything you have learned in the preceding threads is turned upside down. To complicate the situation, the condition for a symmetric distribution is fuzzy. It's defined with skew approximately but not necessarily 0. There is also no guarantee that it will remain small. For example, suppose the skew is slightly positive and price action is around the 1st SD below the VWAP. You would look for long trades back toward the VWAP. But it is also possible for the price action to continue on down with the VWAP crossing the PVP and continuing on down. Like the breakout trade, trading a symmetric distribution has to be done with great care.

By its very nature, a trade taken toward the VWAP in a symmetric distribution is a counter trend trade. For example, when price is below the VWAP, the trend is down as defined in Part II. If you trade toward the VWAP then, you are taking a long entry in a down trending market.
Similarly for shorts.

Look at the first video and see if our trader can decide if the distribution is symmetric.

Symmetric YM Trade

Advice: If you want to counter trend trade in a symmetric distribution, use the Shapiro Effect discussed in post 16541 to decide on the entry. If the countertrend trade is taken at the 1st SD below the VWAP and the trade fails (price action drops below the 1st SD) you have two choices. 1)reverse the trade and take your profit at the 2nd SD or 2) hang on and scale in at the 2nd SD for the counter trend move back to the 1st SD.

Our trader in the first video was so sure that he would not want to take a short trade. But now watch the second video and see what our trader thinks now.

In the second video, our trader takes 3 trades, the first a standard breakout from the PVP area as discussed in Part VII, the second a counter trend trade, and the third in the trend direction after a retrace. The last two trades demonstrate the use of the Shapiro Effect when the distribution is symmetric.

NQsymmetric trades

Clearly trading symmetric distributions is as difficult as trading breakouts. The choices can be quite contradictory.

[BlowFish]

Getting really interesting now. I thought with all the questions you might not have time for this weeks lesson! Great stuff as usual.

[steve46]

For anyone interested, I emailed Howard (Ensign Software) and asked that he program the SD (as Jerry pointed out, the VWAP is available as a DYO study). Unfortunately he declines citing other committments. I am not a programmer so I will look in Esignals code library and if I cannot find it there, I will find a programmer to do the work using that platform (efs). I will try to make it available to all TL members.

Steve

[BlowFish]

A couple of questions. Do you always like to see both conditions before considering a counter trend trade? (flat distribution & PVP aprox equal to the VWAP).

I just wondered if there are other situations where a return to the mean/mode might be anticipated.

Cheers,
Nick.

[jperl]

	Quote:	BlowFish
	A couple of questions. Do you always like to see both conditions before considering a counter trend trade? (flat distribution & PVP aprox equal to the VWAP). I just wondered if there are other situations where a return to the mean/mode might be anticipated.

Good question Nick. Short answer is there are other situations where reversion to the mean might occur. Example being a skew sign flip does do it sometimes. But other than that I don't know what else would.

[jperl]

	Quote:	steve46
	For anyone interested, I emailed Howard (Ensign Software) and asked that he program the SD (as Jerry pointed out, the VWAP is available as a DYO study). Unfortunately he declines citing other committments. Steve

I'm surprised at that Steve. Howard is usually receptive to DYO studies.

[dbntina]

Thanks JPERL I am going through the videos.

Yesterday the NQ and ES both had great breakout
trades against the skew (long) at the PVP/1SD
at 1357/1412 Central and they both hit the 2nd SD!
Granted they were probably risky since the PVP was
at the 1SD but still nice. Of course that means you
would have been stopped on the 2nd short skew trade
if you shorted one contract at VWAP on both ES and NQ
waiting for shapiro effect.

I have to say I am amazed...granted only been following
for a few weeks but there has to be something to this
statistics stuff!

dbntina

[dbntina]

Jerry,

Went through the videos...very nicely done thank you for posting!

Its starting to sink in a little better, couple points if you could confirm are correct for me:

1) Your definition of trend is price in relationship to the VWAP.

Price above VWAP the trend is bullish
Price below VWAP the trend is bearish

2) PVP in relationship to the VWAP tells you what kind of distribution you are looking at.

VWAP above the PVP tells you we are currently in a positively skewed distribution to the long side
VWAP below the PVP tells you we are currently in a negatively skewed distribution to the short side
VWAP close to the PVP tells you we are currently in a symmetric distribution.

If the above statements are correct, I have a couple of questions.

1) My thinking is that skewed distributions tend to indicate trend movements and symmetric distributions
tend to indicate reversions to the mean or a congestion type of environment. This is of course only relevant
to the current situation as the VWAP and PVP relationship can change in the future.

2) It would make sense to me that overall bias (whether you want to take long trades only or short trades only)
would be determined by the VWAP/PVP relationship. Assuming that looking at the volume histogram gives you a pretty good idea that the current bias is not going to change soon:

A) If the VWAP is above PVP you should only be looking for longs (assuming that current bias stays the same). This is regardless of location of price. If price is above VWAP you are trading with trend. If price is below VWAP you are trading counter trend.

B) If the VWAP is below PVP you should only be looking for shorts (assuming that current bias stays the same). This is regardless of location of price. If price is above VWAP you are trading counter trend. If the price is below VWAP you are trading with the trend.

C) If the VWAP/PVP is close it is a big assumption that current bias stays the same unless price moves rapidly back towards the VWAP. So when in a symmetric distribution it seems to make sense to me that you would only trade at 2nd and 3rd SD's for safety reasons in expectation of a move back to VWAP. However, it must move quick or you will not continue to have VWAP/PVP close (symmetric distribution).


Given the above, the first trade on the YM does not make sense to me. We are in a symmetric distribution, why short at the 1SD below VWAP expecting a move to 2SD. If you expect the symmetric distribution to hold, then you are not trading with that expectation. It is more probably to get a move back to VWAP and other side of distribution, then to extend further against the VWAP toward 2SD and 3SD. The only exception would be if you are expecting the VWAP to continue down below the PVP and quickly turn into a negative skew.

You have given examples of 3 main types of trades:

1) Trading a positive/negative skew (non-symmetric distribution) in direction of the trend (defined by relationship of price and VWAP) with risk tolerance and scaling in. This one makes sense to me.

2) Trading a breakout at PVP against the skew in a non-symmetric distribution in direction of the trend (defined by relationship of price and VWAP) without risk tolerance (using tight stops and quick breakeven) makes sense to me because you are trading against the skew (which could change in the future) but you are trading with the trend.

3) Trading a symmetric distribution (assuming it holds) at the 2nd and 3rd SD's with the expectation of a QUICK move back to the