Cyclical Models

A Brief look at Hurst Cycles and Theory:
Reproduced with permission of David Hickson, creator of Sentient Trader http://tinyurl.com/6co9qcn

Cyclic theory (at least the aspect of cyclic theory that Thinking Trading Software uses, as defined initially by JM Hurst) is based on the idea that stock market price movements are the result of the complex combinations of many different cycles. They differ in amplitude (in other words how much price movement they cause), and also in period (how long between each cycle trough - also called wavelength, or the inverse of frequency).  One of the differences between JM Hurst’s theories and many modern day practitioners of cyclic theory is that Hurst constantly emphasized the fact that many cycles combine to produce a composite price movement, whereas the modern team generally talk about cycles in isolation from one another - there is much talk of “identifying the dominant cycle”, and then trading on the basis of that cycle only. That’s all very well, but the hidden secret we believe is all about the ways in which the many cycles combine, and illuminates the reason why tracing only a single cycle can be so disastrous to one’s trading account balance.

A sine-wave cycle

Let us start at the beginning, and try to explain. The basic cycle (of which Hurst says there are many, in fact an unlimited, infinite number), looks like your standard sine wave. Above this paragraph (if we have the formatting of this page correct) is a graph showing two complete cycles of such a sine wave. Let’s assume that this wave is a depiction of the 54-month (4 & 1/2 year) cycle, believed by Hurst to be present in the movement of stock market price movement. That means that something (call it “social mood” or “the X factor”) is causing prices to rise and then fall as depicted in this graph - one complete cycle (up then down) in 4 and a half years. That’s all very well - but this doesn’t look much like a graph of a stock market price, and that’s because a stock market price is moved by a combination of many cycles! So let’s start combining them!

Now in this graph (should be above this) we have combined two sine-wave cycles, using Hurst’s Principles of Harmonicity, Synchronicity and Proportionality. What this means is that the waves have periods that are a small integer multiple of each other (in this case 2 - the pink wave has a period that is 2 x the period of the blue wave), and the troughs of the waves, where possible, occur at the same time (synchronicity), and the amplitudes of the waves are proportional to their periods (the pink wave is 2 times the amplitude of the blue wave). The white line is the combination of both these sine waves (using the Principle of Summation, which basically states that you add them up!) Now the point we are getting to is that a trough in the blue wave (the same 54-month wave depicted above) appears differently to another trough of the same wave, depending on the influence of any longer cycles. So imagine that you were trading this 54 month cycle - you would want to buy at the trough of the cycle, and sell at the peak. If all you did was consider the 54 month cycle, you would have made a very disappointing trade at point A in the graph to the left. Although you have correctly identified that point as being a trough of your trading cycle (the 54-month cycle), the price move up from the trough (as shown by the white line) is very disappointing - it is completely different in scale to the price move up from the trough positioned at the extreme left of the graph. So the point I’m making is that one cannot trade cycles in isolation - one has to consider the cycle in the context of all cycles longer than it.

 Combined cycles from 54 months to 18 years

Unfortunately the situation is even more complicated than combining two cycles as described above. Hurst mentions in his work that the longest known cycle is probably 18 years (and that was back in the 1970’s), and one might ask why one should need to know about cycles any longer than that … well this is the hidden secret we been trying to get to: We believe one does need to know about the longer cycles, all of them (even if they are all lumped into one imperfect and slow movement - what Hurst calls Sigma L) because, as we hope we’ve demonstrated, the longer cycles have a great impact on the effectiveness of the shorter cycle troughs as buying points.

                                                          Combined cycles from 54 months to 54 years

And so one final chart. In this chart we have combined all cycles from 54-months up to 54-years. We believe there are two alternatives for the cycle one up from the 18 year cycle - a 36-year cycle, or a 54-year cycle. The 36-year cycle has a wavelength 2 xs as long as the 18-year cycle, and the 54-year cycle has a wavelength 3 xs as long. We prefer the idea that the 54 year cycle is in fact the next wave up, because of the symmetry with Hurst’s 18-month to 54-month cycles, and also because 54 years is generally considered to be the length of the Kondratieff cycle.  But without actual evidence, We are unwilling to commit to either, and in any case we need not only consider the 36/54 year cycle, but also all cycles longer than them, so the Sigma L “cycle” will by no means be a perfect sine-wave cycle itself. What we have done in the chart to the left is demonstrated both the 36-year cycle (the blue line, composite price is the pink line), and the 54-year cycle (the green line, composite price is the white line).

We have again labeled all the troughs of the 54-month cycle with red arrows, labeled from A to K, and of course there is another trough at the extreme left (or right, because they are the same trough) of the chart. Take a look at each of those arrows, and I think you will agree that trading the 54 month cycle is not merely a matter of buying every 54-month trough. One has to know what is happening to all the other cycles, in order to know whether a particular 54-month trough is likely to result in an impressive price rise. Consider for example point K - that is a 54-month trough, but we certainly wouldn’t want to buy there (regardless of whether the longer cycle is 54 years or 36 years).

So here is the “hidden secret” to cyclic theory:

One can only trade profitably using cyclic theory if one is able to identify all of the cycles impacting upon a particular stock’s price movement at any one time. It is a mistake to say that because price is at the trough of any particular cycle, it will necessarily rise to a degree commensurate with the wavelength of that cycle - the impact of a particular cycle is governed by the status of cycles longer than it (what Hurst calls the underlying trend of a cycle).

Choosing one cycle (as the dominant cycle) is therefore no good as a trading strategy. It was this “epiphany” that has driven us to find a software package that will take this idea into account, and be able to identify the shape of the Sigma L (or sum of all longer cycles) “cycle”.  Sigma L or underlying trend factor.  

The Potential of Trading
Trading offers the potential, if one knows what one is doing of providing a perpetual source of income. We say “if one knows what one is doing”, because we have learnt the lesson of “not knowing” the hard way and after spending a good deal of the last 15 years studying everything we could find about how to trade “knowingly”, we do believe that we’ve found a way of doing it. This “way of doing it” is what I call “The Trading Theory”.

The Trading Theory
this is a trading theory inspired by the original work of JM Hurst, who studied cycles in the stock market (in the late 1960’s and 1970’s). We have added to the theory some extra details, and we believe the theory works (in other words one can make money by trading it) … We have spent a lot of time studying it, looking at it from every angle, and we still believe it works! So what’s the catch? The catch is that this is not a simple theory. It’s not a get-rich-quick theory. It is complicated, and involves several “barriers to entry”:

• a lot of mathematics
• some pretty complicated data crunching (also mathematical, but involving some additional ideas like spectral analysis)
• A willingness to overlook the “why does this happen?” question, which many people find difficult.
• The necessity of applying visual pattern-recognition ability.
• The applying of a specific logic which takes a while to grasp, and a pretty long time to master.

The Problem with Trading
we have many friends who “trade”, in which description we include those who buy stocks and shares for longer term investment. Trading is pretty easy to get into - open an account somewhere, pick a share/currency and then buy it! All too often we believe people get into trading (or longer term investing) without knowing what they are doing, and often do really well for a while (sometimes even years). But then just when they think they know it all, they start losing money, and before they do know it all they’ve lost everything they made in the first place, plus a bit more.

Why does this happen time and again? Because people who trade (or invest) in this way don’t actually know what they’re doing.  We know that’s harsh, but most of the time it’s true. There is a well-known saying in the trading world: “don’t mistake a bull market for your own genius”. If you buy shares in a bull market (which is a rising market) they are pretty much bound to go up. If you then make the mistake of thinking that it was your genius that guided the choice of share, or the time at which you bought the share, then when the market turns into an angry bear (as is happening pretty much worldwide at the moment) and starts falling, you’re going to suddenly realize how little you actually do know.

Our favorite question to friends and people we meet who also trade is: “what guides you’re buying and selling decisions?” Would you believe us if we said that most people don’t really have a “theory” they work with? They listen to other people’s opinions on the radio and TV, and vaguely make a decision based on their “gut feel” about a share. Sure, some of the time they’re right, but let’s face it: some of the time they’re not! That’s all very well if it’s a hobby that amuses you, but if it’s your plan for the future; I think that is pretty disastrous. The way many people talk about trading reminds me frighteningly of the way gamblers speak about their gambling exploits: A gambler will phone their friends in great excitement on the occasion of a big win (a big party for all the friends, everyone talking about how the gambler has a “lucky gene”). But what happens when they lose money? Do they phone all those friends? Not likely, unless they need a loan and so one tends only to hear about all the wins, and none of the losses. All too often we find that happens with traders we have met - great stories about making thousands of dollars in a few days, but not so many stories about the losers. The problem is we think those people are doing little more than gambling with their money. For their sake we really hope their lucky streaks hold well as the world markets twist and turn.

Most of them answer any concerns we express with the stock response of - “in the long run stock markets go up, even if it means you have to wait a little longer”. We must say we think that idea has run its course - there is no rule anywhere saying that stock markets cannot start going down, and keep going down. And even if a market always has to turn back up again, what if it only happens in 80 years time? Might be a little late to enjoy the upturn! The S&P 500 now sits are the same level as it was back in March 1998.  The Dow Industrial 30 sits at the same level today as it was back in April 1999. Over 10 years of markets ups and downs and prices sit at virtually the same levels they were over a decade ago.   We are keen reader of Robert Prechter’s the Elliott Wave Theorist in which he often discusses spurious ideas such as the belief that stock markets must inevitably go up. If you’re interested in trading well, we highly recommend his newsletter - you might not agree with all his ideas, but it’s always good to question one’s own beliefs now and then.

AS of March 24, 2011

 SUMMARY

Total Profit/Loss:                                  $ 17786.50
Number of Open Trades:                     18
Open Trades Profit/Loss:                     $ 2075.27
Total Winning Trades:                         60
Total Losing Trades:                            62
Total Winnings:                                    $ 34505.58
Total Losses:                                         $ -16719.08
Average Winning Trade:                      $ 575.09
Average Losing Trade:                         $ -269.66
Most Winning Trades in a Row:          6
Most Losing Trades in a Row:             9
Win Ratio :                                            49%
Win Ratio LONG trades:                      50%
Win Ratio SHORT trades:                    47%
Profit Factor One (win/loss ratio):       0.97
Profit Factor Two (ave. win/ ave. loss):                        2.13
 
 
Total Time Period:                                6 months, 3 weeks, 1 day
Average Duration of Winning Trade:  2 weeks, 3 days
Average Duration of Losing Trade:     5 days
      

 
Average daily equity change:               $ 96.23
Annualised % return:                           105.45%
Maximum drawdown:                          -9.97% (Saturday, March 05, 2011)
Maximum drawdown (in one day):     -5.85% (Friday, March 04, 2011)
Maximum gain:                                    54.53% (Friday, March 25, 2011)
Maximum gain (in one day):               6.04% (Saturday, March 05, 2011)