Carnac Investment Advisors' Derek Frey explains how market harmonics and chaos theory can help him assess the probability of his trades before he executes them.

My guest today is Derek Frey.  We're talking about market harmonics.  What is that and how do you use it to trade?  Derek, what is market harmonics?

Market harmonics, really in a word, is just taking the natural patterns that exist in nature.  An example I like to use is hurricanes.  Hurricanes are a harmonic pattern.  Harmonics is nothing more than using a specific sequence of Fibonacci ratios, extension and retracement ratios that come together to form a specific pattern.  In the case of hurricanes, obviously the hurricane, but the spiraling arms that we're also familiar with, with Fibonacci and everything, it's obviously inherent in that hurricane and that information has certain implications that we know. 

The spaghetti maps for instance on hurricanes.  We know when there's a low pressure system out in the Atlantic, we have those spaghetti maps.  We know, we don't know exactly what's going to happen, we don't know exactly where it's going to go or how hard it's going to be but we do know there's a storm and we know in general where it's going to go.  Harmonic patterns give us kind of the same information.  They don't tell us with absolute certainty that the market's going to go to 132 tomorrow at 7:15 but they tell us okay, well, there's a storm here and that storm has certain implications and just like if there's a hurricane, there are certain odds that XYZ place is going to get hit.  Well, same thing in the market.  There are certain odds that if a harmonic pattern shows up, just like if a hurricane shows up, there are certain odds that certain things are going to happen and that's the edge.  Every trader is looking for some kind of an edge.  Harmonics, for me, is just the way that I arrive at the edge that I use.

In reading your bio I saw that you use the term chaos and the way it applies to the markets.  What do you mean by that?

Well, chaos theory of course is the whole butterfly effect and the real definition of chaos theory is sensitive dependency on initial conditions so you have what it's really saying without getting too long winded is there's this feedback loop.  We all know that the past influences, the last five bars influence the next one in some way, shape, or form.  It's not a question of if they influence, it's a question of how much and in what way and chaos theory actually gives us a whole bunch of tools that allows us to measure those things and basically say, okay, well, what is the most probable outcome here?  It doesn't mean it's absolutely going to happen, but at least we know where the odds are and again, for me it's just about finding the odds and staying on the side of them and that's it. 

Are you calculating probability of every single trade before you get into it?

Absolutely.  Yeah, I couldn't imagine entering a trade without knowing what my odds of success are before I ever pull the trigger.

Okay, talk about how you actually go about to come to that figure or number.

Well, I use the harmonic patterns as kind of the baseline so when a particular pattern shows up, it tells us with a certain degree of certainty like 70% or 75% or something around there.  It's never 95% or anything like that but 70% or so that we know that there's going to be a 20% move in up or down whatever it is, if it's a bearish or bullish pattern, and then we just position ourselves accordingly.  We're not trying to pretend we know the future.  We're not trying to forecast the future per se, we're just saying these are the odds and if we consistently position ourselves with them over time, we kind of have to be winning more than we're losing.

And on individual trades, the higher the probability, the higher your size as well?

Um, not necessarily because I like to kind of keep size fairly uniform because honestly even if, I've been doing this long enough that even if probability is 70% or 80%, the long-term difference is not huge.  As long as, the biggest thing is being consistent with that edge to try to realize it over a long period of time and a long series of trades.  I think a lot of people fall short because they're only looking at maybe 50 or 100 trades and that's just getting started.

You've got to go out the long-term thousands of trades.

Thousands of trades.  Nobody gets rich in this business off of one or three trades and if they do, they're not the example.