Mastering the Skewness Coefficient: A Guide to Trading Momentum and Reversals

Understanding the Skewness Coefficient in Trading

In trading, the skewness coefficient is a powerful tool for analyzing price movements and understanding market momentum. To better grasp this concept, let’s start with an analogy:

Introduction: The 0 to 100 Speed Analogy

Imagine all cars have a performance indicator called the 0 to 100 speed. However, not all cars reach this speed in the same amount of time. One car might achieve it in 5 seconds, while another takes 10 seconds. This difference in the rate of change is called acceleration or momentum. Similarly, in trading, price movements can accelerate at different rates, and understanding this acceleration is key to identifying profitable opportunities.

Scenario A vs. Scenario B: Which Trend is Better?

Consider two scenarios:

  • Scenario A: A strong, accelerating upward trend.
  • Scenario B: A slower, less dynamic upward trend.

Which trend is more stable and profitable? Clearly, Scenario A. Even within these scenarios, there can be variations in acceleration. Let’s explore this further.

The Role of Tension Levels and Market Psychology

When the price, after a significant move and a proper correction, reaches a tension level (e.g., the golden level), traders who missed the previous move see the price drop as an opportunity to enter. They conclude that the price is undervalued and below its intrinsic value. As a result, they compete to buy, often at higher prices, anticipating that others will push the price up.

  • Scenario A: Indicates increasing buying impulses, decisions, and order flow. Traders are spending more money at a faster rate, leading to higher profit potential.
  • Scenario B: Shows decreasing buying excitement, resulting in a slower and less profitable trend.

Auction Theory and the Skewness Coefficient

In financial markets, prices change based on the decisions and trades of market participants, following auction theory. At the beginning of an auction, participants believe the item (or asset) is undervalued, leading to rapid price increases. However, as the price rises, traders begin to feel it’s overvalued, and the rate of increase slows. This is the foundation of skewness coefficient analysis.

  • Large Traders: Enter early, recognizing undervaluation sooner. Their actions create the order flow change candle.
  • Small Traders: Enter later, often relying on tools and methods for signals.

To maximize profits, traders should aim to enter the market immediately after large traders, at the beginning of the auction.

Order Flow Change Candle: Key Insights

An order flow change candle is the candle that reverses the previous order flow (e.g., from bearish to bullish). However, it may not always be the ideal entry point. For example:

  • If the candle is too large, the trading cost increases, and the stop-loss distance becomes impractical.
  • Ideally, after a correction, small neutral candles should appear, followed by a candle that closes in the upper third (in an uptrend) and covers a few previous small candles.

Challenges in Reversal Trades

In reversal trades, it’s common to see the price hit a key level, show an inability to continue, and then reverse. However, sometimes the price moves against the trade, triggering stop losses. This happens because:

  • The community driving the reversal lacks sufficient power and liquidity.
  • In such cases, traders should either avoid the trade or switch to a higher timeframe for stronger signals.

Missing Entry Candles: What to Do?

Sometimes, a good trading opportunity arises, but no entry candle forms. In such cases:

  • Accept that not every opportunity can be captured.
  • Focus on trading according to the rules, even if it means missing some profits.
  • Remember: Skill surpasses experience. A skilled trader can identify entry points even without a textbook entry candle.
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