I have seen that the stock markets work in a cycle. There is not always uptrend and there is not always downtrend either. This changing behavior of the stock market is called stock market cycles. In this article, I will show you what is cycle principle and how you can trade these visible cycles in the market using Hurst Bands AFL in AmiBroker, our favorite charting platform.
What is the Stock Market Cycles?
By definition, a cycle in the stock market is a time period within which a series of regularly recurring phenomena or events are completed. The cycle principle has been introduced by a man called JM Hurst who has written a book named Profit Magic of Stock Transaction Timing way back in the 1960s. This book is still available today and which has been very popular over the years. In this book, he has presented a very small portion of his full cycle theory. Cycles affect the price movements in the financial markets.
The stock market cycles go from positive to negative and back to positive again. It carries on like this for an infinite time. During its course of action, the market creates peaks and troughs as shown in the picture. The time period between 2 peaks or troughs is called a wavelength.
The 5 Basic Concepts of Stock Market Cycles
There are multiple cycles that influences the price movement in the stock market. In fact, there can be an infinite number of cycles present. But you need not know those infinite number of cycles. All you need to know is to identify as many as cycles as you can.
Cycles Exist in Continuous Time
These cycles affect the financial markets 24 hours a day, 7 days a week and 365 days in a year. The cycles that affect the financial markets exist in a Harmonic Nominal Model as per JM Hurst. The wavelength in this model is related to a simple harmonic ratio.
As we can see from the image above that the longest cycle that Hurst considered was 18 years. Similarly, the shortest cycle considered by Hurst was 5 days. You can see the average wavelength in days and years are also mentioned in the image above. In the subsequent studies by Sentient Trader, the cycles are broken down to as low as 3 minutes as seen in the image. Why this is called a harmonic nominal model because the cycles exist in harmonic relationships. 18 years divided by 9 years is 2:1. Similarly, 54 months divided by 18 months is 3:1.
Variation in Wavelength
This theory tells that the wavelengths will vary in actual from the average wavelengths given in the table.
The cycles that can be identified all will have synchronized troughs. That means they do not have synchronized peaks. We can understand this if we see a picture with multiple cycles.
There are 2 cycles one is blue and the other is pink. The resultant of the 2 cycles is shown in a white line. You can see that the troughs are synchronized while the peaks are not. This is a very important concept and defines how stock market cycles work together. You can see that due to multiple cycles the resultant cycle (white line) will look like the word M.
We have understood that there will be multiple cycles in the market. But in reality, we are going to trade only one. The underlying trend of our trading cycle is the combined effect of all the cycles longer than our trading cycle. So we need to analyze the trends of the longer cycles whether the price is moving up or down. If it is moving up then we add +1 and if it is moving down then we add -1. Suppose checking 4 longer cycles we got the underlying trend of our trading cycle = (1 -1 + 1 + 1) = +2. So the concept of the underlying trend is very important in making the trading decision.
Stock Market Cycles FAQ
The stock market cycles can be shorter or longer. The longest cycle that has been identified is of 18 years and the shortest cycle identified was 3 minutes.
The full market cycle is the market moves up, moves down and moves up again. So it is the journey from a trough to a peak and back to a trough and back to another peak again. So this covers a bull phase, a bear phase, and a bull phase again.
The stock market is not stagnant. Rather it is very dynamic in nature. If the market moves up it must come down to revert back to the mean. And if the market comes down, again it must go up to revert back to the mean again. So the market can not stay over-stretched for a long time in any direction. Rather it moves in a cyclical nature.
What is Hurst Bands?
The Hurst Bands is a statistically effective mean reversion trading tool. It is based on paranomial regression formulas which create deviation channels that can be projected into the future. In simple terms, the Hurst Bands provide a continuously mathematically verifiable entry, trend confirmations, and exit signals. You can trade the stock market cycles easily using the Hurst Bands.
In Hurst Bands there are lines drawn from 1, 2 and 3 fractional deviations or sigma away from the current market price. Statistically, there is only a 5% chance of the price breaching beyond the 2-sigma. Also, there is only less than a 1% chance that the price will breach beyond the 3-sigma. So when price approaches these lines a relatively low-risk entry opportunity arises to trade the opposite direction.
We will be trading the Hurst Bands using AmiBroker and I am providing you with a download link of Hurst Bands AFL for AmiBroker. Whenever we apply this indicator to a chart, the curvilinear structure will appear on it. Price touching any extreme of the bands can be considered for an entry in the opposite direction. Hurst has recommended keeping a trailing stop loss on the trades.
Download Link of Hurst Bands AFL for AmiBroker
I have provided you with the download link of the AmiBroker AFL. I have tested that it works on AmiBroker version 5.60 and above. You can download the same from below.
How to Trade the Hurst Bands?
The trading procedure is simple. Buy when the price touches the lower band and try to move higher on the next day. Sell when price touches the upper band or just sell as soon as you lock your profit. Works pretty well in NSE as well as any market situation. It works in sideways markets very well. The drawback of this AFL is that it does not work very well in the trending markets. So I suggest using this indicator in conjunction with the ADX indicator. Use this in the low ADX situations, which clearly denote that the market is rangebound.
We suggest you to read the original book by JM Hurst to master on this subject.