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As a trader, you will agree that scientific and engineering method is the only legitimate method to improve your profits. Whether you are using correlation, geometric patterns, or statistics, they are science. Even latency arbitrages are just a sort of computer science or engineering, one could dig deeper on how to fine-tune the algorithm, network and internet speed to beat others. If any trading strategy has persistent dynamics towards profitability, we can formulate or describe their working mechanism using known science and engineering principle. Hence, we can reproduce the same mechanism repeatedly for our trading. Most winning trading strategies are based on some sort of precise science and engineering. Profit will never come blindly or by just a chance.
Topic in this article is partly about chaos theory. As one knows, chaos theory as in nonlinear dynamics is a hard-core math topic. However, we will not touch the complex theory because this article is for average trader. The focus of this article is to provide some intuition over this hard science, chaos theory. Chaos theory reveals several characteristic for some dynamic system like stock or currency market. Here is the list of four important characteristics: 1. Highly sensitive to initial condition (i.e. Butterfly effect) 2. Feedback loop 3. Order/Disorder 4. Fractals (i.e. self-similarity) 5. Etc
Firstly, scientist often uses the term butterfly effect. This term describes the situation in which a butterfly flapping its wings in New Mexico cause a hurricane in China. A different way to express this is that small changes in the initial condition can lead to drastic changes in the results. We can meet full of similar examples in our life. One example of butterfly effect is that the rejection of an art application lead to World War Two. This is probably the most widely known butterfly effect. In 1905, Adolf Hitler applied to the Academy of Fine Arts in Vienna. He was rejected twice. After his rejection, he was forced to live in the slums of the city and his anti-Semitism grew. He joined the German Army instead of fulfilling his dreams as an artist. World would been changed a lot if Academy of Fine Arts accepted him. Secondly, feedback loop describe that systems often become chaotic when there is feedback present. A good and relevant example is the stock market. As the value of a stock rises or falls, stock traders tend to buy or sell that stock. This feedback from stock traders will further affect the price of stock going up and down chaotically. This feedback loop produces the fractal wave or equilibrium fractal wave in the market. Thirdly, chaos is not necessarily disorder although people use the term chaos interchangeably with disorder. Instead, chaos suggests that a system can transition between order and disorder. In turn, order and disorder is connected to the predictability and unpredictability of the financial market. In some science, this is called entropy. In fact, this is the main topic of this article. We will get back to this later. Fourthly, a chaotic system can exhibit fractal pattern. We have wrote the comprehensive description on how to use this characteristic in our trading. Please refer to the book: Financial Trading with Five Regularities of Nature: Scientific Guide to Price Action and Pattern Trading. We will not reintroduce this in this article.