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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
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
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
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.