Stocks & Commodities V. 24:8 (20-26): Modeling The Market = Building Trading Strategies by John F. Ehlers
The correct model can form the foundation for comprehensive trading strategies.
Modeling the market is important because you can build comprehensive trading strategies if your model is correct. One example of a successful model is the famous Black-Scholes model for options; a variety
of options strategies have been spawned from it.
Another historical model is the Hodrick-Prescott
filter, which attempts to isolate the trend and cyclic
components of macroeconomic data. It finds the
trend by penalizing variance of the cyclic component.
Once the trend is found, the implied cycle component is established as the difference between the original price and the trend. The Hodrick-Prescott is not applicable for trading, usually being applied to monthly, quarterly, and annual data samples. Philosophically, the Hodrick-Prescott has the construc-tion of the model exactly backward. Rather than first finding the trend, I know we can measure the cyclic component of the market, and by using that, we can derive an “instantaneous” trendline.
TRENDS AND CYCLES
First, we start by assuming that our market model is made up of a trend component and a cyclic component and that we can add those two components together to synthesize a reasonable representation of the market. There are no overt constraints on these two components; the trend component does not have to be a straight line and can curve across the duration of the
price chart. This is the instantaneous trendline.