A market classification scheme is a high payoff strategy for improving your trading results. There are a few things for you to consider as you look to take advantage of your edge in market classification.
Remember that you are not in search of eternal truths for all times and places, for all traders and styles. You are just trying to make a reasonable, risk-adjusted return on your invested time and money to achieve financial freedom. This will take you down different paths than those of the pure academia, with the intent of adding value to your bottom line.
Focus on your time frame for trading. This is especially important if you are looking to supplement your income initially and have not yet made the leap to full time, professional, independent market trading for a living. You will have constraints placed on your time by the competing demands of work and family and there will be some styles that are simply not within your reach. No sense trying to develop a classification scheme for a style that will not fit you. Identify interesting markets and targets for you to specialize in. You want these to offer you the kind of volatility you can trade while remaining in your tolerance for excitement. As a trader you must trade on volatility, the fluctuation of price around the idea of “fair value.” It will be important for you in the early years to focus on markets that you find appealing and interesting and about which you will develop a feel and an expertise that will give you an edge. It is these markets where your classification scheme can be informed by both art and science. Look for a blend of art and science in your classification scheme. Find elements of the market’s behavior that may be expressed as rules, like seasonal volatility cycles, time frames that seem to repeat, and typical patterns and express those elements quantitatively. Find those patterns and themes that seem to emerge in the course of your trading to add an element of qualitative description to your scheme. By blending the best of both worlds you will have a market classification scheme that leverages the two primary domains of your cognition: art and science, qualitative and quantitative reasoning.
Your classification scheme will help you to interpret price into useful meaning, which can be placed into favorable risk-managed action.
Finding an Edge
When you peel back the onion a little and examine the traders who seem to have an edge not completely explainable by luck and the law of large numbers, there are many who have focused on their ability to link an assessment of market conditions for their selected targets to an appropriate strategy designed to exploit their particular edge.
Crucial to this strategy is the development of a market classification scheme that is related to the underlying dynamics of the chosen market and in tune with the average length of holding positions so that favorable moments that are actionable can be identified.
Individual traders who have found a sweet spot for their edge can apply this idea to improve their average returns, and identify moments of higher than average expected returns.
One of the most common quests for trading excellence early in a trader’s career is the search for an all purpose, robust trading secret that can be used to guide the trader through all markets, in all time frames, in any conditions, regardless of the instrument being traded, the size of the position, and your goals and objectives.
In some ways this is a legacy of the increasingly academic pursuit of truth in the marketplace fueled by the need for institutional money and those charged with a fiduciary responsibility for the money of others to employ only the most rigorously tested and objectively powerful strategies. The combination of sizeable management fees and the seriousness of the legal implications of being a fiduciary certainly are compelling reasons alone, but part of me believes that there is also a commitment to the scientific pursuit of objective truth there. Almost every sound piece of academic research establishes that there are no enduring edges that an individual trader can take advantage of and we are advised to follow efficient market theories in various forms to ensure we get the average market returns.
And yet there are traders who consistently make better than average returns. Many are simply lucky and have confused a “to-be-expected” run of luck with skill. They find themselves running out of luck when they are at their maximum exposure level and are never heard from again except as an admonition to avoid timing the markets or aiming for more than average.
It is a paradox, of course, since only by having individual actors striving for abnormal returns will the market mathematically achieve the efficiency required by academic theory.