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Wouldn’t it be great to predict what the financial markets are going to do next? Look at almost any website about investing. There will probably be 3 elements present:
- some information about the market;
- a product that is being sold; and
- some prediction about a market.
The ability to predict may be the product and make take many forms such as software, a new indicator, or a tip sheet or some other way to see what is going to happen.
Being able to predict what will happen is portrayed, and is seen, as the way to profits.
This is a Problem
Striving to predict cannot be the basis on which profits are made for a simple reason: you cannot know what is going to happen in the market. So you cannot predict with any certainty. This does not change no matter how much information you have, or how good your software is.
The result is that prediction is futile and any plan for making decisions or any product that is based on a claim of being able to predict will fail.
Following a plan that is doomed to fail is not the way to become profitable.
This is not a new insight. About 100 years ago, J.P. Morgan, the famous American bank magnate, was asked by a reporter what he thought the market was going to do.
He replied that it would fluctuate, as always. How true.
His answer also shows that even he did not know in what direction the market was going to move. He accepted this and was comfortable with it. So, he made no prediction.
And if J.P. Morgan could not say in what direction the market would move then perhaps we should accept that neither can we.
Being Able to Predict is Still Seen as Important.
It’s easy to see why traders would focus their analysis on trying to predict the market. After all, if you could do that successfully then trading profitably would be more or less guaranteed.
But you cannot know and do not need to know how the market will move in order to be profitable.
So don’t ask: what will happen? Instead, always ask: what is happening in the market?
Focus on what you know and use this information to guide your trading by making decisions regarding different possibilities. Then assess and control the risks that are associated with your decisions.
The market will either move up, down or sideways. By looking at a chart we can know in what direction it has been moving in the recent past.
It will either continue in this direction, reverse direction, or move sideways.
And while we never know for certain which is likely to happen, by observing patterns and other indicators we can aim to assign different probabilities to each possibility.
If a market is in a trend then it continues to move in that direction unless it reverses. And it only reverses once for the trend to be over.
So most of the time the trend is going to continue.
Make Decisions Based on What You Know
A strategy based on this simple observation is quite different from the age old saying that you make money in the financial markets by buying low and selling high.
Obviously this is true – but only in hindsight. Because how do you know that the price the market is offering at any point in time is either high or low?
If the price has fallen and is below where it was last week, is this a low price? If we buy in then perhaps it will continue to fall lower!
This approach will only work if you manage to buy in the short time periods when the price is falling and just about to reverse, or has just reversed. And what are the chances of this given that most of the time the market is not in this timeframe?
Traders make money not by following a buy low and sell high strategy but by buying at the market price and selling at a future higher price – or selling at the market price in order to buy back at a future lower price.
Be Clear About Predictions and Expectations
There are no mysteries here, no secret formulas, no fancy software. Instead there is a proven strategy which combines easily stated and understood rules with experience to make the right decisions when discretion is required and the mental discipline to keep doing this.
But this not the end of the process. Indeed, many writers and experienced traders contend that identifying trades is a relatively small part of the process.
One of the most important aspects of trading is managing risk and deciding not only what to trade but how much. And most importantly, you need to know when to get out of a trade.
After all, no-one ever makes money by entering a trade. You make your profit when you exit the trade.
This means you have to be able to form an expectation about what the trade has to offer.
Indeed, you have to be able to form expectations about what your financial resources can provide to you.
To get a handle, first break the outcome, i.e. the level of returns, down into its determinants and see what might be expected of each element. It’s best to consider this in terms of percentages and so, provided the account is adequately funded to provide sufficient liquidity for trading, the size of the account, within reason, is not relevant.
The return is determined by three variables:
- The percentage of winners among overall trades;
- The ratio of average value of winners to loses
- The percentage of the account that is put at risk on each trade.
One interesting factor to note is that, as we go down this list, your ability to control the outcome in relation to each factor increases.
You have the ability to exercise a high level of control in relation to the final factor, some control in relation to the second, but not have a lot of control in relation to the first.
This is important as most people appear to place most emphasis on the first as the key to success by aiming to identify a strategy that will produce a high percentage of winning trades.
It is understandable why this should be so, but it is also contradictory to place most effort on a factor where there is little chance of success. Far better to concentrate on those elements that can be controlled.
Control What You Can
The percentage to risk you can take on should be known in advance and be treated as an absolute rule, never to be broken.
Control of the second factor will be achieved through setting strict stop losses and targets at appropriate levels – although targets can always be extended – and only investing where the identified potential gain is a predefined minimum multiple of the potential loss. Most authors on trading recommend that this should be in the range of 2.5 or above.
So, a trade is only taken if the analysis indicates that the potential gain given the market’s behaviour is 2.5 times the value of the amount that is placed at risk with the stop loss having been set also based on the market’s behaviour.
This leaves the first issue in the list: the percentage of winners. This is where many people make mistakes.
At first sight it would appear that someone who knows nothing will achieve 50% winners in a financial market, and this is true to an extent (ignoring commissions and other costs).
However, this expectation ignores a key issue which is that making profits requires not only that you get the direction right i.e. a long trade when the market rises, but that you also get the timing right.
You may very often find that an expectation that the market will rise over a certain period proves to be correct, but it takes a dive first before doing so. You are correct on the direction was right but your timing can be wrong and you may lose money.
Controlling Risk Affects Outcomes
The only way to avoid this would be to set a very wide stop loss or none at all. The result is that if we do aim to control our risk then we will no longer achieve 50% winners by random trading.
Instead, we will have 50% losers due to direction and perhaps in the region of a further 40% of the remaining trades will lose due to timing issues.
On the basis of these figures the expectation should be that in the region of 30% of trades will be winners i.e. 50 out of each 100 trades will lose because the direction is wrong and 20 will lose due to timing issues with the trade being stopped out before it moves in our direction.
Only 30% winners! Surely not. And this is where inexperienced traders make the mistake of starting to search for the golden strategy that will provide 60% or 70% winners.
But the evidence is that successful experienced investors target and expect that perhaps 35 to 40% of trades will be profitable. The important point to notice is that if they have controlled the factors that they can control they are very profitable.
Some Simple Arithmetic on Expectations
Assume a fund of $10,000 with 1 trade per day over the course of a year of 240 trading days, with 2% risked per trade, 35% winners and a ratio of winners to losers value of 2 to 1. These seem like quite conservative assumptions.
A total of 156 trades lose money with each one losing $200. There are 84 winning trades and each one wins $400. Total profits for the year are $2,400 or 24%.
If maintained over a prolonged period this would be a very profitable business with the fund at the end of 10 years having risen to $86,000.
Far from being conservative, this would be a hugely successful outcome.
However, inexperience investors entering a market find it hard to accept that losing over 60% of the time should be considered to be normal and concentrate on trying to improve their analysis rather than their risk control and trade management.
If this results in them paying for systems that promise to predict the market and achieve higher wins rates they will increase their costs and will be distracted from what is really needed.
Even more seriously, some focus on trying to improve returns by relaxing the risk constraint and increase their position sizes. This is the greatest danger to their accounts.
Steven has worked for over 15 years as an analyst in financial markets and in developing products for retail investors. Steven understands what drives the financial system and writes on how people with just a little knowledge of the system but with the will to succeed can benefit from managing their own investments.