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A Theory of Market Action: Part II

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In the previous post, we discussed the need for a good theory that provides a framework for one’s research to generate sustainable trading models. I also promised a quick survey of two existing theories and their shortcomings.

 

In this post, we discuss the first theory: Theory based on supply and demand.

 

Before we proceed, we take a short digression to clarify certain points.

 

Both hypothesis and theory try to describe a phenomenon. Take the Dow “theory” for example. It states that prices moves in waves. This is an observation. Observations are neither theories nor hypotheses. Since Dow did not describe why prices move in waves, we don’t have any parameters to measure.

 

What separates a theory from a hypothesis is the ability to measure. Take the Fractal Market Hypothesis (FMH) for example. FMH describes the reasons for market action. Unfortunately, at this present time, there is not tool to measure all the parameters in FMH. Until such tools are found, FMH will remain a hypothesis.

 

A note also has to be made on the falsify-ability of a theory. In order to falsify a theory, the measurements have to be accurate. Unfortunately, in the field we are in, accurately measuring the [hidden] parameters of a theory is not always possible. This is the reason why a theory in trading can never be falsified based on measurements alone; this (accuracy of measurements) is the same reason why trading will always be a game of probabilities. In fact, if all hidden parameters of a market can be accurately measured, the market will cease to exist. Just because a theory cannot be falsified based on accuracy of measurements does not make it a hypothesis.

 

If trading is a game of probabilities, the goal, then, is to get one’s probabilities higher than the rest of one’s peer group. This can be achieved by increasing the accuracy of measurements of a theory’s parameters – the reason why Wilder and the turtles were more successful than the Edwards & Magee type traders. But what if the accuracy of measurements amongst one’s peer group is almost same? Then, the only way to increase one’s probabilities is to improve the quality of the theory: a theory that uncovers hidden, measurable parameters that better describe the actions of the market – a topic we are concerned about.

 

Lets get back to the survey.

 

Theory based on supply and demand: Wyckoff’s theory of market action and its variants

More than 150 years ago, in 1848, John Stuart Mill wrote a vivid description of speculative market behavior:

 

”The inclination of the mercantile public to increase their demand for commodities by use of all or much of their credit as a purchasing power, depends on their expectation of profits.

 

When there is a general impression that the price of some commodity is likely to rise, from an extra demand, a short crop, obstruction to importation, or any other cause, there is a disposition among dealers to increase their stocks, in order to profit from the expected rise.

 

This disposition tends by itself to produce the effect which it looks forward to, a rise of price; and if the rise is considerable and progressive, other speculators are attracted, who, so long as the price has not begun to fall, are willing to believe that it will continue rising.

 

These, by further purchases, produce a further advance: and thus a rise of price for which there were some rational grounds, is often heightened by merely speculative purchases, until it greatly exceeds what the original grounds will justify.

 

After a while this begins to be perceived; the price ceases to rise, and the holders, thinking it time to realize their gains, are anxious to sell.

 

Then the price begins to decline; the holders rush into the market to avoid a still greater loss, and, few being willing to buy in a falling market, the price falls much more suddenly than it rose.”

It is this description that Richard D. Wyckoff tried to formalize in his theory (those interested in his theory are referred to the Wyckoff forum). His theory has six measurable quantities: demand, supply, cause, effect, effort, and result. [Please note that Wyckoff also provided “how-to” instructions; our immediate purpose is not to survey them.]

 

A note on recent developments in behavioral finance: Finally, the academic community has decided to pay attention to the above-mentioned “Mill Process”. The result of their attention is the field of behavioral finance. As it stands now, the tenants of behavioral finance can be viewed, among others, as explaining the demand and supply components of the Wyckoff theory. So, for the purposes of this post, we can “roll” those models into the Wyckoff theory. The same argument can be made for the theory of reflexivity, a concept borrowed from the field of social sciences and applied to economic by George Soros.

 

Tools to measure Wyckoff’s theory of market action

 

The word “measure” is used very loosely in this post. This word should be read not necessarily with the rigor one would expect in a quantitative measure but as a synonym of estimate in a heuristic sense, wherever applicable.

 

Wyckoff himself advocated the use of then existing tools to measure [the variables in] his theory: bar charts and volume to measure supply, demand, effort, and result; and PnF charts to measure cause and effect (a.k.a accumulation/distribution areas)

 

Tom Williams later introduced VSA, a different interpretation of the bar charts and volume, to measure the demand, supply, effort, and result components of the Wyckoff theory. He too advocated the PnF charts to measure cause and effect.

 

The works of Robert D Edwards, and John Magee used bar charts in-by-themselves to measure supply, demand, cause, and effect. The assumption they worked on is that price action in-by-itself captures the variations in supply and demand, and that using volume in addition to price action was unnecessary. According to them, price formation (or patterns) provided clues (measures) of market conditions (demand, supply, cause, and effect of the Wyckoff equation). Our intent is not to argue for or against the merits of their argument, but to provide a survey.

 

The work of J. Wells Wilder, published through his book in 1978, revolutionized the field of measuring tools by introducing the concept of “indicators”. “Indicators” are nothing but statistical transforms of underlying data streams. Over the course of years, different statistical transforms have been developed that helped provide quantitative measures of all the variables in the Wyckoff market theory.

 

A note on the usage of the word indicator in this post: By definition, the purpose of an indicator is to indicate. However, an argument can be made that consecutive price bars (and or volume bars) in-by-themselves are indicators as they indicate the direction of price action (a single price bar doesn’t indicate anything useful, but it is by comparing successive price bars that an indication is provided). Further more, when we get to the section on Market Profiles, the word indicator become over-loaded: a single market profile graphic is both an indicator – it indicates where the value area is, which in-by-itself is useful – and a summary statistic of the underlying data just like a single price bar. So, to avoid confusion, the word indicator will not be used in this post, instead the word statistical transforms will be used.

 

As can be seen in this section, a plethora of tools, both quantitative and otherwise, are available to measure the variables in Wyckoff’s theory.

 

It has to be noted that traders who don’t trade using the ideas of market profile, knowingly or unknowingly adhere to the theory of supply and demand as presented here.

 

Short-coming of Wyckoff’s theory

 

Wyckoff’s theory is a good starting point. However, it has one glaring shortcoming.

 

In order to fully understand a system, the system has to be expressed in its principle components. Only the principle components of the system are allowed to be influenced by external stimulus.

 

In the case of Wyckoff’s theory, when we ask the question “what is the reason for demand and supply?”, we get an answer “because people buy and sell”. People buying and selling (external stimulus) causes demand and supply (principle components) in the system.

 

However, when we ask the question “what is the reason for effort and result, or cause and effect”, we get an answer “because of the actions of composite operator”. Clearly the parameters effort, result, cause, and effect are symptoms (second order parameters) of the composite operator’s actions (which causes composite operator’s demand and composite operator’s supply within the system).

 

Why is this important? In a system like ours, where accuracy of measurement is a problem, second order parameters over amplify measuring errors resulting in, not increasing one’s trading probabilities, but plausibly reducing them.

 

A new theory should take into account the trading mechanisms of market makers (or commercials or liquidity providers or whatever name one prefers). Adding this variable to the theory of market action creates a principle component, if properly measured, can provide clues to the actions of the market makers – a very valuable information to traders. We, then, now longer need to measure the second-order Wyckoffian parameters cause, effect, effort, and result.

 

A concluding note, in support of Wyckoff: Wyckoff designed his theory to promote his how-to methodology to retail traders when the information available to retail traders was very limited. The author contends that Wyckoff had not other option but to include the parameters cause, effect, effort, and result in order to educate the retail traders in his how-to methodology. The author applauds his efforts. Given the information we have today, we can do better.

 

In the next post, we will discuss the theory based on value (Market Profile) and its shortcomings.

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It has to be noted that traders who don’t trade using the ideas of market profile, knowingly or unknowingly adhere to the theory of supply and demand as presented here.

 

I wonder if that's not overstating things, in light of (to name just a few examples) pairs traders, or traders who bet on time decay, or cross-market arbitrageurs.

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I wonder if that's not overstating things, in light of (to name just a few examples) pairs traders, or traders who bet on time decay, or cross-market arbitrageurs.

 

Richard,

 

I should have made the context clear. The target of that statement was people who exclusively trade one instrument.

 

As I had stated in Part I of this article, inter-instrument activities (like pair trades, arbitrages, etc) are more about efficiency than about market supply and demand, and hence discussing those types of trading was outside the scope of this article.

 

If a person (naked) shorts way out-of-money options to profit on time premium, they would be an exception to my statement. However, a person trading naked options to profit from price action of the underlier would benefit from this article. (Note: if one tries to profit from theta by maintaining a fully hedged position, I would consider that inter-instrument activity. I would also consider gamma or vega trading to be a inter-instrument activity)

 

Thanks for raising this point.

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n the case of Wyckoff’s theory, when we ask the question “what is the reason for demand and supply?”, we get an answer “because people buy and sell”. People buying and selling (external stimulus) causes demand and supply (principle components) in the system.

 

However, when we ask the question “what is the reason for effort and result, or cause and effect”, we get an answer “because of the actions of composite operator”. Clearly the parameters effort, result, cause, and effect are symptoms (second order parameters) of the composite operator’s actions (which causes composite operator’s demand and composite operator’s supply within the system).

 

Great series of posts. I didn't stumble upon it until III MP (which is right on the money imho). Anyway.........

 

Effort and result, cause and effect are not really parameters of the system. It could be argued cause is external to the system and that effort is an internal variable that is constructed from inputs. It could also be argued that result/effect is the output (as measured by price change) .

 

Terms like "composite operator" and "smart money" are hooey and cloud something that is a reasonable model for market behaviour. The model does not need to know who is buying or why. Actually there are many types of participant with a variety of objectives and modus operanti. They are external to the system all the system needs to know is that they are buying or selling.

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Great series of posts. I didn't stumble upon it until III MP (which is right on the money imho).

 

Thank your, BlowFish.

 

Effort and result, cause and effect are not really parameters of the system. It could be argued cause is external to the system and that effort is an internal variable that is constructed from inputs. It could also be argued that result/effect is the output (as measured by price change) .

 

My understand of Wyckoff is that 'cause' results in an 'effect'. The 'cause' is accumulation and distribution areas, while the 'effect' is the price movement due to the 'cause'. Wyckoff did use this as parameters to his system, since this is what his theory measured using the PnF charts.

 

Your are correct in that 'effort' and 'result' are measured by the price + volume chart in the Wyckoff theory. That is precisely why I consider 'effort' and 'result' to be parameters in the Wycokoffian theory.

 

Terms like "composite operator" and "smart money" are hooey and cloud something that is a reasonable model for market behaviour. The model does not need to know who is buying or why. Actually there are many types of participant with a variety of objectives and modus operanti. They are external to the system all the system needs to know is that they are buying or selling.

 

I might have a different taken on this. You will see my line of thinking when I present the proposed theory of market action in Part IV of the series.

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