## The Five Regularities in the Financial Market – Price Action and Pattern Trading Course

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3. The Five Regularities in the Financial Market

The Financial Market is the place where different investors are trading securities

like equities, bonds, currencies and derivatives. It is the market place to facilitate

the exchange of securities between buyers and sellers. Loosely speaking, the

financial market works like the auction market where buyers enter competitive

bids and where sellers enter competitive offers at the same time. However,

unlike auction market, in the financial market securities are often traded

without delivering actual physical goods. Although some companies can use

financial market to hedge their physical positions, in this book, we will assume

that you are more of speculator who wants to profit from the market dynamics.

Various buyers and sellers with different attributes, different geographic

location, different purchasing power and different financial goals, forms the

daily transactions of the financial market. Therefore, the dynamics of financial

market can be represented as the crowd behaviour. It is not necessarily perfectly

rational place but the fundamentals play some important role behind the

market dynamics up to some degree.

For traders and investors, it is important to develop the right trading strategy

for the market. Good trading strategy never comes blindly. Understanding the

underlying dynamics for the financial market is the important requirement to

build a solid trading strategy. Then, what is the underlying dynamics for the

financial market and how can we study them to benefit our trading and

investment? Scientists had a strong interest in the dynamics of the financial

market for many decades. They have extensively studied the dynamics of the

financial price series in the Stock and Forex market. The simplest but most

effective way to study the dynamics might be the decomposition approach. In

decomposition, literarily we are breaking down some complex system into the

simple and digestible bits. Then we use this decomposed bits to predict the

behaviour of the complex system.

When we apply the decomposing technique for price series, the price series can

be decomposed into several sub price patterns. In fact, the sub price patterns

are the regularities that constitute the dynamics of the financial price series

(Figure 3-1). For trading and investment, we make use of the knowledge of these

regularities to predict up or down movement of the financial market. All the

known trading strategies, including simple and complex ones, are based on

some of these regularities existing in the price series. Remember that none of

trading strategies is merely created to offer you just some luck or based on some

random theory.

Figure 3-1: The concept of the decomposition for the financial price series.

In Figure 3-1, what could be the pattern 1, pattern 2, pattern 3 and pattern N

making up the real world financial price series? Yet, many different version of

decomposition techniques exist to describe the price patterns in the financial

market. Among them, Gardner’s version considers the trend and seasonality as

the main underlying components of the price series data (Gardner, 1987, p175).

Many traders are already familiar with trend in the financial markets. For

example, many technical indicators like moving average and MACD were

developed to visualize trend in the financial markets. Seasonality is literally

seasonal fluctuations in the market. It is also used by many traders. For example,

because the sales of Ice Creams increase during summer, stock price for Ice

Creams Company can go up due to the increased profits during summer. This

sort of patterns will make up the seasonal fluctuations.

The Gardner’s framework is intuitive and easy to understand because trend and

seasonality are the backbone of many analysis techniques used for the

univariate price series in many scientific fields. Although Gardner’s framework

does not mention about random process explicitly, his framework already

assumed that any price series include some random process.

Depending on their underlying dynamics, the price series can show the

multitude of behaviours because real world price series are made up from

different magnitude of each price pattern. For example, sometimes, the price

series can exhibit strong trend without seasonality and vice versa. Sometimes

the price series can exhibit some trend with some seasonality. In the Gardner’s

trend-seasonality framework, we can generate twelve different behaviour of the

price series by combining the basic trend and seasonal patterns as shown in

Figure 3-2. Scientist uses this framework to categorize many real world price

series data set for prediction purpose. Then, what is the practical use of the Price

Pattern Table in Figure 3-2 for traders? As a trader, we can develop trading

strategies to capture these price patterns within the price series. For example,

most of technical indicators are created to capture trend pattern in the price

series. Price patterns in price series are regularities, which help us to predict the

price series into the future. Financial trading is based on our prediction for the

future market. We buy EURUSD because we predict that EURUSD have the high

chance to go up. We sell EURUSD because we predict that EURUSD have the high

chance to go down. If we understand the existing regularities of the financial

market better, then we will likely make better trading and investment decision

too.

Figure 3-2: The original Gardner’s table to visualize the characteristics of

different time series data (Gardner, 1987, p175). Gardner assumed the three

components including randomness, trend and seasonality in this table.

In spite of the fact that trend and seasonality are the important price patterns

in the financial market, practically the entire financial market will not fit to this

trend-seasonality framework alone. If the market was so predictable with these

two components only, then traders and investors were able to make money

much easier. Maybe you can also take advantage on buying shares of Ice Cream

Company during April and selling them late August. If the pattern is there, then

you should do that. However, in the highly competitive and liquid financial

market, this is not the case. In many cases, the trend and seasonality might be

the less significant components in the financial price series in the Stock Market

and Forex in comparison to the data obtained from the business and social

studies. The Gardner’s trend and seasonal framework can work well for business

and some social data set but it might be oversimplified for the case of the

financial markets.

Instead of the two components framework with trend and seasonality, in this

book, we propose the three components framework. The three components

include Equilibrium process, Wave process and Fractal-Wave process. These

three components can serve to conceptualize the basic price patterns existing

in the financial price series. Just like the trend and seasonal components in the

Gardner’s framework, these three components are the building blocks to explain

more complex price patterns in the financial price series and to predict the

future movement of the price series. Just to convey our idea, we will explain

these three components in brief, before we expand each in more details from

the next chapter.

The Equilibrium process is equivalent to the trend in the Gardener’s framework.

However, it is also the same term “equilibrium” used in the supply- demand

economic theory. Literarily it is the market force moving the price to release the

unbalance between supply and demand. Wave process is any cyclic patterns

repeating in the fixed time interval. Wave process includes the concepts of

additive and multiplicative seasonality in the Gardner’s model. Furthermore,

Wave process includes other complex cyclic behaviour, which can be described

with the multiple of combined sine and cosine waves. Finally, the Fractal-Wave

process is the representation of the Fractal geometry in the time dimension.

Therefore, it is the self-similar process repeating in different scales. In plain

language, Fractal-Wave process refers to the repeating patterns with varying

scales. For example, trader might remember that the price patterns in the S&P

500 before 2008 financial crisis. He can come across the similar price patterns in

lower timeframe or in other instruments. Because he has already seen that the

price pattern led to the huge bearish movement for S&P500 before 2008

financial crisis, he would take the sell action again whenever he recognize the

similar patterns from lower timeframe or from other instruments.

Just as Gardner visualized the possible combinations of trend and seasonality in

three columns in Figure 3-2, we can visualize the possible combinations of these

three components in five columns. In Figure 3-3, first three columns including

Equilibrium Process (=trend), Additive Seasonality and Multiplicative Seasonality

are identical to the Gardner’s three columns. Fourth column includes any simple

and complex cyclic patterns, which can be described with the combined sine and

cosine waves. Fifth column describes the Fractal-Wave process with Equilibrium

process. Each column represents a distinctive regularity with its own behaviour.

We can describe the five columns as the five regularities in the financial market

(Figure 3-3 and Figure 3-4).

One most obvious distinction among the five regularities is that each regularity

has the distinctive range of number of cycle periods as shown in Figure 3-5. In

general, Second and Third Regularity have very few cycle periods. Fourth

Regularity tends to have more cycles but the number of cycles is still finite. The

Fifth Regularity can be characterized by the infinite number of cycles because

the repeating patterns can have the infinitely varying scales within the price

series. Therefore, it becomes very clear that we need to use different tactics

when we deal with each regularities.

Especially, the fifth regularity is the underlying process behind many horizontal

and diagonal price pattern used by traders. The horizontal and diagonal price

pattern can include the popular price patterns like support, resistance, harmonic

patterns, Elliott Wave patterns, Triangle, Wedge and Channels, etc. This book

mainly focuses for the fifth regularity because the fifth regularity is the main

price dynamics behind many price action and pattern trading strategies. In the

book, we want to help you to understand the clear difference between this fifth

regularity and the rest. We will focus to cover the practical trading knowledge

for this fifth regularity. Finally, we will help you to learn the price action and

pattern trading strategy in the practical level throughout this book.

There are many different data in the Stock Market and Forex. Remember that

different players are participating in the different markets. Each financial price

series will be played by different players with different attributes and different

psychologies. Therefore, each price series can have their own dynamics because

they possess different price patterns in different magnitude. For example, some

stock market price series can possess much stronger Equilibrium process than

currency price series in the Forex. Practically speaking, the most of the price

series in the Stock market and Forex will have either the mixed effects of

Equilibrium process and Wave process or the mixed effects of Equilibrium

process and Fractal-Wave process. This means that they are a highly

complicated system representing the crowd behaviour of millions of people.

Once again, the main purpose of this taxonomy is to identify regularities existing

in the financial price series. Therefore, traders can make prediction for their

trading. The five regularities framework can be used to build any trading strategy

for different financial market. For example, there is no need to apply hammer

when the entire house was built with bolts and nuts. In addition, the medical

doctor will prescribe you the medicine for cold when your symptoms are very

close to other patients having cold. Likewise, if the financial price series exhibit

strong trend and multiple cycles, then you should just apply the right tools to

capture the strong trend and multiple cycles for your trading. If you are applying

the tool to capture trend only or if you are applying the tool to capture cycles

only, then you will be underestimating the market. Therefore, you will be

suffering more than enjoying the profits. Practically speaking, trader should

know what regularities they are dealing with and what tools they need to apply

to capture those regularities.

From next chapter, we will describe the sub price patterns under these five

regularities in details (Figure 3-6). Especially, we will focus to explain the

combined price patterns like Equilibrium Wave process and Equilibrium Fractal-

Wave process. It is because the price patterns in the real world financial markets

are likely to be one of these complex patterns. We will try our best to visualize

each price patterns with example. However, for Forex and Stock market, it is not

easy to find them showing simple trend pattern or seasonal pattern alone. As

we have mentioned before, highly competitive and liquid market are likely

showing more complex patterns like Equilibrium Wave process or Equilibrium

Fractal-Wave process. Therefore, when we explain an obviously simple price

patterns, then we might use some data set not from the Forex or stock markets

because it is difficult to find Stock or Forex market data showing trend pattern

alone. For example, in explaining the Equilibrium price patterns, we use UK

housing price to show you how the typical Equilibrium dominated price series

look like. Sometimes we might use some synthetic price series to visualize some

price patterns in Figure 3-6.

After we have covered all the sub price patterns in next few chapters, we will

move to the practical part focusing on the fifth regularity for your trading. The

fifth regularity is the least understood but most confused price patterns among

trader comparing to the rest of the regularities. Especially, the characteristic of

the infinite cycle period tells us that many technical indicator, we were using

without any doubt, can reduce your profitability or at least they can act as an

inefficient element in your trading. Simply many technical indicators are not

designed to deal with the infinity but they were designed rather to reduce the

noise from the price series by smoothing or averaging. When you do not

understand nature of wave in the price series, these technical indicators can

take away many good trading opportunities from you.

In addition, traders observe many horizontal and diagonal price patterns every

day because of the Equilibrium Fractal Wave propagation. We want to bring the

unified view or just one simple concept encapsulating these price patterns for

both educational and practical trading purpose. The commonly used term “raw

price action” among the price action trading community does not provide much

explanation for beginners or any relation to the already established trading

practice and concepts.

In doing so, first, we will help you on how to identify those price patterns using

the Peak Trough Analysis technique from your charts. We present several

different Peak Trough Analysis technique for your trading. Please note that we

provide free Peak Trough Analysis tool in our website. Second, we will presents

the actual trading strategy especially designed to deal with the infinity of the

fifth regularity. We will look at the increasingly popular trading strategies for this

purpose. We will start with the support and resistance to introduce some

fundamental trading knowledge on the price patterns. Then we will further

expand it with the popular trading strategies like Harmonic Pattern, Elliott Wave,

Triangle and Wedge patterns. These trading strategies are over 80 years old and

used by many reputable traders in the world. Several traders thought that these

strategies are connected but it is difficult to find the literature level of claim yet.

We show that these advanced trading strategies can be explained in one notion,

the fifth regularity (Figure 3-7). At the same time, we will reveal the powerful

trading recipes you can use for your practical trading in this book.

Figure 3-3: Five Regularities and their sub price patterns with inclining trends.

Each pattern can be referenced using their row and column number. For

example, exponential trend pattern in the third row and first column can be

referenced as Pattern (3, 1) in this table.

Figure 3-4: Five Regularities and their sub price patterns with declining trend.

Each price pattern can be referenced using their row and column number. For

example, exponential trend pattern in the third row and first column can be

referenced as Pattern (3, 1) in this table.

Figure 3-5: Visualizing number of cycle periods for the five regularities. Please

note that this is only the conceptual demonstration and the number of cycles

for second, third and fourth regularity can vary for different price series.