Trading Proverb #5, Equilibrium

Trading Proverb #5. Understanding equilibrium will make you rich.

Remember the day your teacher talked about the bell curve? Did you pay attention? It is the secret to wealth.

The data can be used to distribute samples in correlation and regression analysis. In this analysis the data will produce a line of correlation in which the majority of samples lie within control limits. These control limits determine standard deviation and in most cases are sufficient to 3 deviations.

In trading, you can create these control limits through an indicator called a Bollinger band. Rather than being a straight line, the Bollinger band uses a set moving average and then calculates the control limits and automatically draws them on your chart.

That is your tool. But you still need to define equilibrium. Simply put, this is a moving average that price will gravitate to and then push away from. The push can be a bounce or a break through the moving average. Once you figure out the moving average that best fits the data for your currency, then use the indicator that I previously advised. Remember? The indicator with the range you most prefer. Set the period of that indicator to the equilibrium moving average. Now, every time the price crosses the moving average on the chart, it will also cross the 0 line or 50 line of your indicator.

If you did a good job, there are still probably instances where the indicator runs out of range and shows overbought or oversold. This is where the moving average placed on the indicator comes into service. Again this value should be a factor of the period setting of the indicator. In essence it changes your indicator to a higher time frame with each multiple. Adjust to find the spot when the indicator can cross the moving average and give you a good probability that a change in direction is really going to happen. Then make the Bollinger band for that moving average and place it on the indicator. You will need to remove the original moving average though, or the Bollinger band might try to reflect the moving average rather than the indicator.

Now you can see when price has moved the farthest away from equilibrium and is likely to return to it. This is some handy information.