Wednesday, 14 September 2011

Occam's Razor

Occam's Razor is the first expression, I believe, of the principle to KISS - keep it simple, then you're not stupid. It talks about the fact that the simplest explanation for an occurrence is the best.

In early times, it was taught that the sun revolved around the earth. Copernicus was punished because he disagreed with this teaching and said that the earth revolved around the sun. The proponents of the incorrect theory, introduced a host of extra rules and exceptions to try and justify their incorrect view. Copernicus' proposition was a simple explanation to all the observations and of course, simple was best and correct.

In our trading, we try too hard to complicated things. Order flow determines market direction. It has to. Liquidity providers take the other side of the trade but eventually they too have to join the direction of the order flow to cover.

Until their is sufficient order flow in one direction and a trend develops, markets randomly move around reacting to short term orders.

Our challenge as traders is to look through the noise and recognise the order flow that will give us a profit. We use a number of tools as well as relying on market psychology to unravel this puzzle. But keep it simple as the more complications you add, the more contradictions and analysis paralysis you will encounter. It is tantalising to add more and more to a chart in order to be "sure" but in fact has the opposite effect. The proof of this proposition is when I create an algo and add, say, 6 indicators that line up, I end up with very few trades in my backtesting and an algo that fails the walk forward test. Yet when I use the simplest of trading principles, I achieve my goals of win rate, profitability and robustness.

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