Hello there! And random walk model

Beginner Questions
1

Hi all :),

sorry for my poor English. I’m new to FX trading. I’m a telecom engineering student and while trying out a couple demo accounts, I tried to put my mathematical analysis / probability / signal theory notions to good use and elaborate a mathematical model which I could later use to create a reasonable strategy for a mini live account.

Given the huge amount of money traded (which should make it very hard for anyone or anything to influence the market directly), has it already been considered to model FX trends with a random walk, at least on a sufficiently wide time scale? Combined with the stddev indicator tool which I’ve seen on some trading platform, I think it could provide an excellent basis for a model.

I tried to build a very simple strategy built on this model, and I got a 95% success rate (although I’m calculating this just on the 20 trades I made so far after elaborating the model, which [B]can’t[/B] be statistically significant – but it’s still encouraging). The catch is that when I lose, I lose much more than what I profit on the average trade.

So anyhow, back to my question: do you think the random walk model is a valid one? What are other valid mathematical models?

Thanks,
Dario

2

I believe any method that incorporates trend-following, chart patterns (including candlesticks), or support&resistance levels, which takes into account good risk management has the potential to be profitable.

I do not believe however that a statistical model, that does not utilize one of the above trader psychology patterns, can have a true “edge” over the market. Even if you do find a mathematical pattern, I’d be willing to bet that it can be traced back to a psychological pattern of traders.

3

Lot of newbies to trading; stocks, commodities, fx
have a tendency to over-think and over-analyze.

And don’t get in the mistake of applying math, statistics,
or any level of statistical modeling to the concept
of trading. Please.

I myself only use a little bit of news from CNBC and
Heiken Ashi Smoothed trending indicator candlestick.
That’s it.

Bottom line: trading the market with market makers,
professional smart money, and fellow traders is not
about math.

4

Thanks for your answers.

Of course I don’t mean that such a model should be used blindly, but I have reason to believe that, in conjuction with trend-following and knowledge of the most common patterns to know where to open and close (rather than these techniques alone), it could yield fairly decent results.

Is there such things as a free tool that I could use to test different models and strategies on historical data (including stop and limit orders?)

Thanks,
Dario

5

Consider 2 things. First the vast computing skills and access to PhD mathematicians the banks have. Are you likely to outdo them? Second if they do find an edge how long do you think it takes the market to catch up and render their edge meaningless

6

Search metatrader4 & mq4 on google.

7

Mathematicians don’t worry me, they usually suck at modelling real-life situations – that is what engineers are for! :stuck_out_tongue:

But apart from jokes, maths is a tremendously powerful tool when you know how to interpret your results and error propagation. I don’t think I have the multimillionaire strategy at hand, I’ve just jotted a couple ideas and I’ll wait till the end of my finals to perfect and test them extensively on a demo account.

At least for me, knowing that I can estimate the probability of winning / losing a trade (which is trivial with a random walk model) and the risk/reward ratio would take away [B]a lot[/B] of dangerous emotions out of my “real” trading. That can’t be bad.

As for what you say, FX has got to be a zero-sum game. I don’t have to aim at taking money out of banks, just out of people who don’t use a valid and consistent strategy like I can only hope mine will be :wink:

8

Finding a mathematical pattern would be way out of my league (and I definitely agree with you that patterns are mostly psychological, especially in day trading, even though I don’t know much about FX at all), but finding a model is much much easier :).

9

Well I have no doubt a model could help define an edge in the market, but what exactly are you going to model? You have to have somewhere to start, I mean you can’t just expect to “model” the workings of the entire foreign exchange market.

10

To put it simply: a random walk has a Gaussian distribution in which stop losses and take profits are vertical lines cutting the distrubution function, the first on the negative side, the second in the positive side (the X axis is the P/L).

The probability of incurring in a stop loss is the integral in X of the distribution function from -infinity to the stop loss value. The probability of incurring in a TP is the integral from there to infinity. Knowing the stddev of the distribution, you can calculate what are the SL and TP values that guarantees an expected value of profit that is > 0.

It’s not actually that easy, but I hope I gave you the idea. Math rocks!

11

I can appreciate what you are trying to do, but don’t be so sure that stddev/variance will be so easy to figure out. The market is by nature prone to have bizarre spikes in prices, coinciding with spikes of emotion (fear/greed). This can be extremely difficult if not impossible to incorporate into a statistical model.

But that isn’t even my main point. What I’m getting at, is if price is moving because traders/investors are reacting to news/technical support&resistance and other factors that are unknown BEFORE they happen, why would you spend your time trying to predict those events. Don’t you see that you are adding an extra step between the underlying cause of the movement and your eventual reaction to that movement. Why not just learn how to model the average traders response to certain events (ie. encountering a resistance level), and profit that way? Trying to account for the market’s total volatility, at all hours of the day, seems extremely futile to me.

12

Some trading platforms have a stddev indicator, so I think it’s absolutely feasible to estimate it (and predict it to some extent) for a certain time frame. If sddev moves back and forth, I can use a sub-model to take that in consideration too.

Like I said, I won’t be using this strategy blindly, but I’ll have to take into consideration fundamental analysis too (especially on when to enter a trade). However I still think it could result in a decent analysis tool to help decision-making.

I don’t really know much about FX, but I tend to think that the effects of traders psychological response have diminishing effect on larger time frames, so my model would be more accurate in intra-day trading. However I see your point… you’re right, I should consider the hour of the day too.

Well, I better go back to studying now ;). But thanks, you gave me some very good inputs.

13

The problem with random walk and all of that stuff is it’s based on the idea that market returns are normally distributed. They absolutely are not. I would strongly suggest reading Mandelbrot on the subject. He does a very good job of pointing out the flaws in classic financial/economic theory, and how that results in much larger than expected risks being taken, though I won’t say he’s solved the question of how to forecast price movement.

14

Well Outspan, I see that you have only 8 posts to your credit. :mad:

Havn’t been here very long have you? :stuck_out_tongue:

And already you are displaying a high degree of arrogance by spouting mathematics which is quite irrelevant to trading forex.
Yes, I am a mathematician too, but I find that doing Fourier analysis, binomial distributions, line integrals and Legendre polynomials is a total waste of time.
To do so, one would have to live in “la la” land.

I believe in living on Earth, not on Mars.

Firstly, do you not even know that the random walk theory is a [U]load of bunk[/U].
Shame on you!
Where have you been?
There is absolutely [U]nothing random[/U] about the price action in forex.

The prices are based on human factors such a greed and fear.
You cannot quantify them, nor can maths predict the outcome of news event.

So you can forget mathematics.

The price patterns of these human factors have been worked out long before you came on the scene. They are called [U]candlestick patterns[/U]. These patterns are very accurate and make any mathematics look quite silly.

But you can live in your fairy tale, philosopy, ivory tower world of nebulosity if you wish.
Please do not talk philosophy to me because I will be happy to take your money off you!

Lets see you talk again when you actually start trading.
Thats when the rubber meets the road!

We will see if you actually become more real after, say, 300 posts on this forum (if you last that long).

Your head will come out of the clouds [U]real quick [/U]after you have lost your account a few times!! :smiley: :smiley:

15

So [B]I[/B] am the arrogant one? I rather have 8 decent posts than 740 like yours. And FYI already admitted not knowing much about Forex, you’re not really saying anything new to me.

It’s sad to see that a “mathematician”, like you call yourself, doesn’t know his own subject can be used for concrete matters too. Do you think that oscillators and momentum indicators, which predict all the patterns you talk about, are just falling out of the sky?

16

To Outspan :

Firstly, I apologize for not welcoming you to this forum.

We are allowed to disagree, yes, of course I know that the indicators are mathematically derived.

But more to the point, you do not understand that I am trying to protect you, trying to stop you from potentially losing all your money. I sense from what you say, that this is the way you are heading.
[U]
Losing all your money is so easy to do in forex.[/U]

Trading is a very practical business, the market is merciless, and quickly knocks out anybody whose mind is not on the practical nitty gritty here and now.

I have been here for a while now, as you can see by the number of my posts.

Quite a few Newbies come on this forum with fanciful ideas.

The veteran traders, (and I like to think that I fit in there), quickly grab hold of these people and try to steer them in the right direction so that they learn accurately and avoid losing their money.

I do not know if you have completed the Baby pips school.
If not, that is the place to begin.
It is very practical and most helpful.
In it you will learn money management, an area of psycholgy that is essential for success in trading.

So yes, my first post to you was agressive, but for a very specific purpose.
If you can see it in that light, you will then understand why I did so.

Good trading to you,
but be warned, stay [U]very practical [/U]and remember the KISS system.