Figure 6-1: Equilibrium process is corresponding to price pattern (2, 1), (3, 1) and (4, 1) in the table.
Simply speaking, Equilibrium process is conceptually similar to trend. It is the market force moving the price series in one direction. Equilibrium process is not different from the equilibrium concept found in the classic supply-demand economic theory. Literally, it is the force to move price to release the unbalance between supply and demand. There are many types of Equilibrium process (trend). They might be linear trend like Pattern (2, 1) in Figure 6-2 or they might be nonlinear trend like Pattern (3, 1) and (4, 1) in Figure 6-2. The three trend patterns, that are linear, exponential and damped, are common. Exponential trend (3, 1) represents the strong trend with increasing momentum. Damped trend (4, 1) represents the trend with reducing momentum. Figure 6-2 presents the six trend patterns for both bullish and bearish markets. These six trend patterns are found most frequently in the financial market comparing to other trend patterns.
Figure 6-2: Trend Patterns for bullish and bearish market.
Equilibrium process is highly related to market fundamentals. Equilibrium process is the direct representation of the supply demand balance in the financial market. Assuming there is the fixed number of shares for Google, if more people want to buy a stock than sell it, then the share price for Google will move up. We call this as a bullish trend. Likewise, if more people want to sell a stock than buy it, there would be greater supply than demand and the price would fall. We call this as a bearish trend. When there is the imbalance in supply and demand force, then the price will try to move towards equilibrium to release the imbalance. The supply demand imbalance is often caused by the fundamental change in the market. For example, change in the taxation or interest rate can change the quantity of supply and demand force dramatically. Natural disasters like Earthquake or Hurricanes or other serious transmissible diseases can influence the dynamics of supply demand too in the financial markets. War, terror, or other political corruption can reduce the demand of the financial assets affected by them.
Figure 6-3: Economic Supply Demand curve.
If the Equilibrium process (trend) is overwhelmingly dominating in the price series, prediction is easier. However, the strength of Equilibrium process differs for different financial price series. It is also not easy to quantify or to isolate the portion of Equilibrium process from rest of regularities perfectly. In reality, Equilibrium process can be caused by multiple information sources introduced in different time (Figure 6-4). Each information source will be diffusing across the market in time. Some of them are slowly and some of them are quickly. Some information source will introduce bullish Equilibrium process, which increase demand and reduce supply. Some other information source will introduce bearish Equilibrium process, which reduce demand and increase supply. Since each trader and investor will react differently to different information sources, the diffusion process of each information source can vary dramatically. Modelling or visualization of diffusion process of multiple information sources is complex. If there are many bullish and bearish Equilibrium process acts together in the price series, the simplest way of guessing the market direction is calculating the net of bullish and bearish equilibrium process in the market. However, with simple netting, you will still miss the time factor because each information source will be diffused in different speed. Another difficulty comes from quantifying bullish and bearish strength of each source. Typically, to quantify them correctly, we need good amount of historical data. Especially if you need the accuracy for trading quality, you will need much more data than just doing some academic research. To most of average trader, this is not accessible.
Figure 6-4: EURUSD candlestick chart with various Fundamental Data Release.
Therefore, trader uses technical indicator because technical indicator is simple alternative to the complex diffusion process modelling. Moving average type of technical indicators can work well for this type of market because they eliminate randomness and leave the trend pattern in the price series. Simple moving average, exponential moving average and zero lag moving average can be the great help for this type of market. Normally the strong Equilibrium process can be captured with typical momentum trading strategy. For example, all moving average cross over strategy will work well. In this type of market, following trend is wiser than using the counter trend trading strategy. The real question is “Can we have such a simple market we can trade with moving average alone”? If so, we will be very lucky. Most of time, the financial market will show more complex behaviour, which will be introduced in later chapters. However, in some stock market, you might be able to find few easy opportunities. In Forex market, I think there is not so much opportunity to win with moving average indicator alone.
Figure 6-5: Moving Average Cross over strategy. Fast simple moving average is cross over slow simple moving average for buy opportunity.
Figure 6-6: Moving Average Cross over strategy. Fast simple moving average is cross down slow simple moving average for sell opportunity.
About this Article
This article is the part taken from the draft version of the Book: Scientific Guide to Price Action and Pattern Trading (Wisdom of Trend, Cycle, and Fractal Wave). Full version of the book can be found from the link below:
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