The Science Behind The Signals

“The major revolution in the last decade is the recognition of the “law of maximum entropy production” or “MEP” and with it an expanded view of thermodynamics showing that the spontaneous production of order from disorder is the expected consequence of basic laws”.

It is intuitive that markets would follow the 2nd law of thermodynamics and tend toward entropy, or balance – after all the core function of markets is to find that price point where the maximum amount of exchange can take place with both buyer and sellers in agreement, i.e. buyers and sellers in balance. It is however counter-intuitive that news coming into the market, to provide further definition, would have the opposite effect. In other words no news leads to balance, while new news leads to imbalance. And often enough in today’s markets new news leads to exacerbated imbalance. And imbalance leads to volatility, or an increase in the rate of change, which in trading terms means we are in a “fast market”. This is why price movement slows down ahead of major news events and often speeds up considerably the moment the news is released. What all this means is markets are definitely chaotic. Because of this they are also fractal in nature and subject to basic laws of physics, one which we already mentioned, the 2nd law of thermodynamics which states that closed systems tend toward entropy. The second, which is so important because markets are not closed systems, deals with interference. In physics interference is something that happens when two waves come together. It is also what happens when related markets become correlated.

Today’s market reaction following the important U.S. Non-farm Payroll release provides a text book example of entropy and interference in the markets – see Figure 1.

Figure 1.

Before the news is released at 7:30 AM on the line chart in Figure 1 the two alpha markets: the S&P 500 in white and the USDJPY in black, are moving along in tight sideway ranges, while the more emotional Euro and Aussie are showing choppier, albeit still sideways trade. The news is released showing much stronger than expected U.S. jobs growth and all markets respond immediately with powerful rallies. As the volatility increases the Euro turns lower taking the lesser traded Australian Dollar with it. However volatility quickly comes out of the alpha markets as they hold their gains. Volatility is still at its greatest however in the Euro, but there is no more news, no more new information, therefore entropy, or balance sets in. and the negative interference created by the Euro going opposite of the alpha markets reverses. This reversal higher in the Euro and Aussie is supported by established correlations and known as positive interference. Once the news is disseminated the markets balance themselves out and return to a state of positive interference.

What was even more noteworthy was that from a mathematical perspective market patterns for both the Euro and the overall market place as measured by our Risk Tolerance Threshold Ratios were bullish even before the number – see Figure 2.

Figure 2.

What this means is the collective, or majority pattern in EURUSD was aligned with the collective pattern of the overall market place. So we already had EURUSD earmarked as a target for buying shallow dips. This means that all the scientific jargon aside, as traders, that price dip following the NFP release was just what we were looking for!

Jay Norris is the author of the best-selling Secret to Trading Forex, Futures and ETFs: Risk Tolerance Threshold Theory. To see Jay highlight trade set-ups and signals in live markets go to Live Market Analysis

Trading involves risk of loss and is not suitable for all investors.

Twitter Digg Delicious Stumbleupon Technorati Facebook Email

About Jay Norris

Jay Norris is Director of Education at Trading University, has over 30 years of trading experience, and is the best selling author of "Mastering The Currency Market", McGraw-Hill, 2009, and "Mastering Trade Selection and Management", McGraw-Hill, 2011. He has also been published multiple times in Technical Analysis of Stocks & Commodities magazine.

No comments yet... Be the first to leave a reply!