All right, its time to tackle some important questions and controversies. Do cycles exist in financial markets? Even if they exist, can we trade them profitably? Perhaps it’s often debated only on first scale and completely ignored on second scale basis. Let me take a dip into the topic and some insights alongside.
Do cycles exist in financial market?
The dictionary definition of a cycle is that it is “an interval or space of time in which is completed one round of events or phenomena that recur regularly and in the same sequence.” In the market, we consider a classic cycle exists when the price starts low, rises smoothly to a high over a length of time, and then smoothly falls back to the original price over the same length of time. The time required to complete the cycle is called the period of the cycle or the cycle length.
Cycles certainly exist in the market. Many times they are justified by fundamental considerations.The clearest is the seasonal change for agricultural prices (lowest at harvest), or the decline of real estate prices in the winter. Television analysts are always talking about the rate of inflation being “seasonally adjusted” by the government. But the seasonal is a specific case of the cycle, always being 12 months. Other fundamentals-related cycles can originate from the 18 month cattle-breeding cycle or the monthly cold-storage report on pork bellies.
Business cycles are not as clear, but they exist. Business cycles vary with interest rates. The government sets objectives for economic growth based on its ability to hold inflation to reasonable levels. This growth is increased or decreased by adding or withdrawing funds from the economy and by changing the rate oat which government lends money to banks. Easing of rates encourages business; tightening of rates inhibits it. Inevitably this process alternates, causing what we see as a business cycle. Although in practice this cycle may repeat in the same several years, the exact repetition of the period is not necessary. The business cycle is limited on the upside by the amount of growth the government will allow (usually 3%) and on the downside by moderate negative growth (about-1%), which indicates a recession. The range of the cycle from +3% to -1% is called its amplitude.
Components of cycle
Statisticians and economists have identified four important characteristics of price movement. All price forecasts and analyses deal with these elements:
1. A trend, or tendency to move in one direction for a specified time period.
2. A seasonal factor, a pattern related to the calendar.
3. A cycle (other than seasonal) that may exist due to government action, the lag in starting up and winding down of business, or crop estimate announcements
4. Other unaccountable price movement often called noise.
Since points 2 and 3 are both cycles, it is clear that cycles are a significant and accepted part of all price movements in financial markets.
Can we trade them profitably?
Er.. That’s a tough question to answer; perhaps I would like say it’s a hardcore truth. We can’t trade cycles profitably. Yes, now I may get criticism from every side arguing how cycles can used for harnessing profits and some stories of calls made by cycles etc.. Yeah. all these are valid arguments, only theoretically not from a practical perspective, I don’t disagree with cycles but certainly they can’t be used for profitable trading purposes. Why? Unlike the cycles which exist in nature is different from the cycles witnessed in financial markets. Multiple cycles interact with each other creating different outcomes at different periods. Think like this-There will be a cycle in short time frame and another in large time frame both of the cycles consist larger scale cycles and short-term cycles like a fractal as mentioned by Mandelbrot in fractal market hypothesis
If many cycles reconcile with each other it creates a chaos which seems like random market movements such a random market variables leads to false forecasts and misinterpretation of reality.
People who use cyclical trading strategies such as Elliot-wave, Gann etc often tend to have less probability ratio than moving averages! Because not only the so-called waves are subjective but also exist in multiple time frames at the same time leading to different outcomes. For eg. there may be a corrective wave in daily chart and impulse wave in hourly chart both of them seems like forming within each other, but most of the pundits don’t know that Impulse wave in hourly chart has the tendency to change the daily, weekly or even monthly price movement!That’s the reason why a lot times there are bad forecasts and misaligned analysis from cycles.
Arguments that cycles exist in the market arise not only from fundamental considerations or direct measurement but also on philosophical grounds related to physical phenomena.The challenge for technical trader is to recognize which period cycles are present and to trade them in a logical and consistent manner while doing so leads to analysis paralysis. These cycles may or may not contribute to profitable trading depends upon each individual.