Less experienced traders lack the sensitivity to discriminate between relevant and irrelevant information presented by a candlestick chart. The rationale for our approach to overcoming this issue can be understood through Green and Swets (1966) Signal Detection Theory (SDT). SDT attempts to explain how individuals differentiate between information-rich patterns and background noise.
According to SDT an individual’s ability to discriminate between relevant information and background noise is primarily determined by the strength of the signal compared to background noise, and the sensitivity of the individual to discriminate between the two. An experienced trader benefits from a greater sensitivity to subtle changes in chart dynamic that may be overlooked by their less experienced counterparts.
Errors in signal detection manifest as errors of omission (missing relevant stimuli) and errors of commission (responding to irrelevant stimuli). As such, a highly proficient technical analyst that is capable of precisely distinguishing between relevant and irrelevant stimuli is able to reduce errors of both types.
Since the time taken to develop such skills cannot be mitigated another approach is considered. Errors in signal detection can be reduced by increasing the discriminability of relevant and irrelevant stimuli. For the novice, this is the fastest way to reduce errors of omission and commission.
By making it easier for the analyst to ‘see’ relevant stimuli against background noise we can augment performance during the formative period of a trader’s development. This is achieved by creating a chart with minimal background noise and pronounced stimuli. To understand how this is achieved compare the following charts.
The red and green chart is a regular Japanese candlestick chart. Japanese candlesticks are coloured based on Open, High, Low and Close prices. A candle that closes higher than the opening price is coloured green and a candle that closes lower than its opening price is coloured. This tells the analyst how price has behaved in the duration of that candle’s formation. Above you can see the same chart with TrendMaster candle colouring rules.
When the candles are white we expect trend continuation to the upside and when black we assume continued selling pressure. It is immediately clear that the TrendMaster chart has drastically reduced the number of directional decisions facing the analyst. Thus it is easier to discriminate relevant signals from background noise. With the directional component of decision making taken care of, we must consider trade entry management and exit criteria. Below I will outline the various components of TrendMaster Premium and how they are combined to provide a complete trading system.