How To: Think Like A Trading Algo
Humans think in stories, and we try to make sense of the world by telling them. Humans have the excellent capabilities of finding (visual) patterns in almost anything, for example we probably all have heard or seen the images of Jesus appearing in the crème of a cappuccino.
It actually is just a beautiful play between the brownish coffee and the whitish milk, but our brains are hardwired to make assumptions, connections and patterns, so it goes into overdrive, dives into our gigantic database of images and finds a match; one of the most recognizable faces, in this case that of Jesus.
We do this all the time in our daily lives (and even at night while we sleep), most of it is part of an unconscious process. But sometimes we go looking for it ourselves on purpose, especially traders.
If you are like me, one of the first things you learned about is probably pattern trading, and the second thing you learned is that these patterns reliability score, isn't by far high enough to be a profitable long term strategy on their own. (they have their place in trading, but cant be used solely on their own)
There is a big reason for that and we are going to dive into it.
The big reason is because you are mainly trading not against people (who have a strong bias for relying on pattern recognition).
But against algorithms (which rely on math), these are deployed by Institutions, Trading Firms, Market Makers, Whales & the curious retailer, I myself do trade a portion of my portfolio as well with algo`s.
The scale of Algorithmic trading is so immense, that within Forex it is estimated to account for 92% of the traded volume. In US equity markets it is estimated to be between 60–72%. The numbers for crypto aren't really known, but of course you can imagine how high this percentage must be, when the whole crypto sphere is about digitalization.
Practical Example: Below is one of the most recent big moves we have seen past month.
It is the 4th of May, we have been compressing into a falling wedge pattern for weeks, and we are about to go into an important FOMC meeting where the next rate hike will be announced.
Below was my price prediction with what I think would be the most “amusing” outcome, we were trading within the falling wedge pattern (which according to the pattern playbook breaks upwards)
I predicted we would “break out” of it (this would trap euphoric breakout traders, which is a classic), just to fall back down of it and breakdown towards 32k by 10th of May.
Why? well, if you look at what the Algo`s would see, you wouldn't see a potential for a breakout, instead you would see a big downtrend on higher timeframe, we were trading below the 180 EMA on the 4H(which can be considered somewhat of a “fair value” line).
So once we approached the 180 EMA, a lot of Algo sellers were looking to offload at the fair value price (because we haven't seen that price point for weeks at that moment) .
For verification purposes, here is the link to my tweet with the price prediction on 4 May
The pattern trader sees a falling wedge, a breakout which he longs because “Trend reversal”, but ultimately he gets caught and trapped with his long, because the algo`s sees something entirely different and start to sell relentlessly.
The Algo sees a downtrend and price momentary returning to a place of fair value and high timeframe resistance, so they start to initiate sell orders, because mathematically its the best place to do so.
So, now what? Well, don’t worry. These algo`s work with a coded set of rules. Most of them operate on a mathematical basis so if we use some of these math based tools ourselves, we can start to see what they look for.
The most important one is the use of EMA`s (exponential moving average). A lot of traders have a hard time to get the overall direction of the market right.
With the use of EMA`s it gets easier to spot the general / high timeframe trend. As it is used to identify a trend and might even be used as some form of guidance on what a “fair price” might be.
That is also one of the main fallacy`s with trading solely based on patterns, the momentum and trend aren’t well represented by them.
So the best EMA`s to use in my opinion are the 180, 50, 21 and 13 Close. For watching the overall market trend I would suggest looking for confluence between the 4H, 12H and Daily Timeframes.
For intraday trades I find it best practice to find confluence on the 15min and 1 hour chart.
And that's how you set the first step on thinking like an Algo: Trade the Trend & The Trend is Your Friend
On Friday 20th May I will get more in depth on this subject and we are going to dive into VWAP, which is another mathematical tool that Algorithms use for anticipating and buying local bottoms, so stay tuned for more!
Hope you liked the Article and maybe even learned something! If thats the case, kindly follow me. I publish articles once / twice a week. Usually I tweet under @BullfortJordan, but as you may understand, 140 characters aren’t really suited for Sharing market insights and strategies.
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