3 Trading Predictions and Expectations
Look at almost any website about trading. There will probably be 3 elements present: some information about the market; a product that is being sold; and some prediction about a market. This prediction 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. The impression that is created is that being able to predict what will happen is the way to profits.
Except that it is not. You cannot know what is going to happen in the market so prediction is futile and any trading plan or product that is based on prediction will fail. Following a plan that is doomed to fail is not the way to profitable trading.
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. And his answer also shows that even he did not know in what direction the market was going to move. 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.
Still, 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? Then ask: how will I react to what the market does?
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. So, 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.
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.
So, 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 is 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. So 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 trading in general 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:
One interesting factor to note is that, as we go down this list, the trader’s ability to control the outcome in relation to each factor increases. The trader has the ability to exercise a high level of control in relation to the final factor, some control in relation to the second, but does not have a lot of control in relation to the first. This is important as most traders 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.
The percentage to risk on any trade should be known in advance and be treated as an absolute rule, never to be broken. A limit of 2% of your trading fund is a commonly stated rule. 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 taking trades where the identified potential gain is a pre-defined 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. At first sight it would appear that a trader who knows nothing will achieve 50% winners 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 a trader gets the direction right i.e. a long trade when the market rises, but that the trader also gets the timing right. A trader may very often find that the analysis that the market will rise over a certain period proves to be correct but it takes a dive first before reaching a target and a stop is hit. The direction was right but the timing was wrong and the trade is a loser.
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 the best traders 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.
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, new traders find it very difficult to accept that losing on over 60% of their trades 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 higher wins rates then they will increase their costs and will be distracted from what is really needed. Even more seriously, many traders focus on trying to improve returns by relaxing the risk constraint and increase their position sizes. This is the greatest danger to their accounts.