Positive trade expectation occurs when the perception of the probability of a price event diverges from the actual probability (see 3 rd Law of Trend Dynamics). Michael Steinhardt describes a similar condition as “variant perception”.

Traders who act on noise as if it were information have made an assumption about the probability of a specific market outcome that diverges from actual probability. For example, a MO trader might go short based on a specific market event which he believes has not been fully realized in price and he trades on the expectation that offers will continue to dominate and extend price to a new low. Therefore, the MO believes that a new low is more probable, than a large rally.

But, if that information has already been discounted or offset, due to quicker execution, faster signals, superior information or anticipation by other traders, then the assumed probability upon which the MO trader is operating is based on negative expectation (divergent from the actual probability of a new low) and this introduces an opportunity for positive expectation for those taking the opposite side of the trade. A VAL trader observes the Noise traders presence in the form of a price too high away from value and detecting positive expectation, takes the other side of the trade.

Identifying the presence of Noise traders in various and specific contexts reveals exploitable market inefficiencies. Noise makes profits possible.

The Crude Oil, weekly chart below reveals an example of variant perception. The actual analysis that we used to determine that the potential for variant perception was in place at X, below, draws on much more detailed refinement of the ideas presented in Article II. The analysis present here is a generalization.

Hurricanes Katrina and Rita stimulated a emotional run-up in Crude Oil in the late Summer of 2005, but the bids broke suddenly and a sell-side order flow imbalance dominated the price structure as Crude sagged for 2-3 months. As price rallied in early December (the red vector) the offers were broken and lost their dominance.

When price declined to X, the news was dominated by the buzzword “demand destruction” implying that price had risen so sharply that a certain level of underlying demand for energy was destroyed. Moreover, news sources were also quoting Boone Pickens, the savvy hedge fund trader, as forecasting a drop to $55.

At X, there was a variant perception as trend-followers held a perception of a drop to new lows that was at odds with the actual probability because the offers were no longer dominant, at X, as they had been on the well-offered decline from mid-Sep into late-Nov.

But, identifying a trade location where Noise traders are active only reveals the potential for a trade, the second requirement is a triggering mechanism where the conditional probability of a price reversal is detected at the earliest stage possible. Both conditions must be present to identify a trade with asymmetrical risk-reward.

Technical traders use price patterns as triggers which they believe have various degrees of intrinsic value, meaning they reveal transient inefficiencies, directional biases, or temporary periods of non-randomness.

But, the intrinsic value of a specific technical trigger is generally nominal. The real value is the impact the pattern can have on the outcome of conditional probability. In other words, the absolute value of a price pattern is a product of the intrinsic value of the pattern modified by the context (see the 8 th Law of Trend Dynamics).

In the daily Crude chart, below, a buy-side price pattern developed in the shaded area with intrinsic value for a short-term directional bias, but the absolute value was greatly enhanced because of the market context (variant perception) that was already in place at this low.