Rogue waves and chaos theory in financial markets

Can the chaotic swings of the Earth's oceans be mirrored in financial markets?

Are “rogue waves” a phenomenon in Forex?

In the Earth’s oceans, those huge bodies of liquid sloshing around, occasionally a series of waves will assemble and give rise to a “rogue wave”, multiples of the size of the surrounding waves. Rogue wave peaks are matched by their troughs. This makes tying this natural phenomena to the financial markets attractive concept. Despite rogue waves being caused by a completely different set of inputs, they may well form a similar enough chaotic system to be able to mirror within the markets and its multitude of competing inputs of its own.

The end plan being a trade immediately following a rogue wave forming, riding it back down or up. A process also known as “fading” a move. This process may be more directional in equities, where the gravitional force of ever expanding markets tends to pull everything upwards over time. In Forex it may be more cyclical as price oscillates around a stable exchange rate for days or weeks at a time.

The challenge in implementing it is in estimating the average sea-level, and then determining what constitutes a rogue wave. One simple approximation could be VWAP as a daily basis line, the sea level, with its standard deviations as the wave heights. Anything above the 2nd standard deviation would be a reasonable estimate of “rogue” waves. 1st SD perhaps forming increased volatility, or choppiness before the rogue appears.

We have timeframe as an issue here, however, as price could take 60 bars to exceed the 2nd SD on the minute (M1) chart, but obviously 4 or 1 on the M15 or hourly, making the move seem much more rapid. A nice way to measure this algorithmically may be to wait for the volatility of the previous rolling window to die off, and we can assume a rolling over is occurring. This is a crude method, but perhaps a starting point. Anyone who has tried to trade bollinger band reversals will know that chasing every return into the bands can be a recipe for low win rates. There has to be a further filter, some form of confluence, as they say.

Trading these freak events on an intraday basis with vwap is of course also possible on higher timeframes, but this might serve as a point of interest.

I have made bots based on this before and they have been reasonably successful without any intervention. I’m going to take another run at these now that I have a better tool for measuring volatility, being well placed to automate the recognition of reversal points. I’ll also look to do the opposite, catch the wave forming on the breakout, using volatility breakout for confirmation.

“A 2012 study confirmed the existence of oceanic rogue holes, the inverse of rogue waves, where the depth of the hole can reach more than twice the significant wave height.”

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