Introduction
The Volatility Response Model (VRM) treats the foreign exchange market as a Complex System consisting of many traders. A Complex System is just a system with lots of interacting components. The murmuration of starlings in flight is an example of a Complex System, where individual birds fly randomly in zigzag paths but the flock as a whole has a continuous and rolling boundary. The VRM describing an FX market is explained in more detail below.
Contents
Origin of the VRM
On a typical trading platform for foreign exchange there is a huge amount of choice: at least 10 chart types, 25 technical tools, 25 drawing tools and 10 pattern types. To choose between these analysis tools requires a lot of experience and knowledge. The author developing the VRM asked the question:
Is it possible to calculate future support and resistance levels mathematically?
The answer is yes! The VRM calculates these support and resistance levels in the future using historic data.
The VRM
In the diagram below, the VRM is the mathematical function that relates one candlestick to the next candlestick in the past. This mathematical function remains the same between all candlesticks in the past. The VRM function then takes one step into the future.
Daily timescales
The VRM starts with as much historic daily high, low and close data as possible, going back more than 15 years. From this, the next future day's high, low and close are calculated. We call these H1, L1 and S1 respectively. Now, what to make of the future predicted S1? Is this the predicted close at the end of the next day? It turns out that S1 is the sentiment level that lasts throughout the next day. Above S1 the market is bullish. Below S1 the market is bearish.
Now take the daily data and combine them in pairs to create high, low and close data for two-day candlesticks. Repeat the mathematics and obtain a prediction for the high, low and close for the next two days. We call this H2, L2 and S2. Once again S2 turns out to be the sentiment level of the market throughout the next two days.
Now repeat the process by creating historic data for three-day candlesticks, four-day candlesticks.... and so on.
We repeat the mathematics out to eight days into the future using eight-day historic candlestick data. This gives us H8, L8 and S8. We now have 24 levels. That is eight H levels, eight L levels and eight S levels.
Weekly timescales
The process just described can be applied to weekly high, low and close data as well. There is no difference in the mathematics. We still end up with 24 levels: eight H levels, eight L levels and eight S levels. This time, however, H1, L1 and S1 describes one week into the future, and H8, L8 and S8 predict for eight weeks into the future.
How long do these predictions last?
The VRM calculates the high, low and sentiment levels up to eight time periods into the future for either eight days or eight weeks, but these predictions will only last for either one day or one week respectively. Once the day or week is completed, the algorithm is used again for the next day and week to take into account the price action that just happened.
Sentiment levels
The eight future sentiment levels at both the daily and weekly timescales calculated by the VRM algorithm are critical.
The daily sentiment levels steer the short term trend of the FX market, and the weekly sentiment levels steer the long term trend of the FX market.
When an FX market becomes bullish in the short term, its price will rise above the highest daily sentiment level, and this level will become a support level. Vice versa, when an FX market becomes bearish in the short term, its price will fall below the lowest daily sentiment level. When the FX price action is trapped within the daily sentiment levels, this indicates that in the short term the FX market cannot agree on a trend direction at the eight different timescales.
Similarly, when an FX market becomes bullish in the long term, its price will rise above the highest weekly sentiment level, and this level will become a support level. Vice versa, when an FX market becomes bearish in the long term, its price will fall below the lowest weekly sentiment level. When the FX price action is trapped within the weekly sentiment levels, this indicates that in the long term the FX market cannot agree on a trend direction at the eight different timescales.
Experience with FX markets has shown that the eight daily sentiment levels and the eight weekly sentiment levels can be simplified. Only the highest sentiment level, lowest sentiment level and S1 are important. The other five sentiment levels can be ignored. This simplifies the analysis.
Short and long term trend channels
The final predictions of the VRM for the future are a short term trend channel on a daily timescale and a long term trend channel on a weekly timescale. The short term trend channel interacts with the long term trend channel. The short term trend channel can rebound off the long term trend channel.
The short term trend channel is steered by the daily sentiment levels and the long term trend channel is steered by the weekly sentiment levels.
Market support and resistance levels
The daily levels, weekly levels, short term trend channel and long term trend channel are levels at which foreign exchange prices retrace and reverse. Placed on a trading chart, you can see these retracements and reversals happening at these VRM levels as the FX market evolves into the future.
In summary, FX markets do not move randomly, but move about the levels calculated by the VRM.
The VRM provides a road map or obstacle course through which the future price action will move.
Click on the link below to find out more about the properties of the VRM and why the mathematics is called the Volatility Response Model.