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Kane Trading
on:
The Myth of 'Predicting'
the Market
Warning: You may find this article a little provocative,
and like most of my work it may challenge some of your currently held
assumptions. Try to have an open mind as you read it.
One of the things that I'm
constantly saying is that I trade the market from a probability standpoint. It
has been my experience that getting a handle on what that actually means has
been, perhaps, the most difficult concept for me to grasp of all the concepts
that I have explored in the trading game. And this is coming from someone with
extensive training in mathematics, a person who at one time was a math teacher.
Yet I still struggled for a long time to understand what trading from a
probability standpoint actual meant.
Eventually, after a lot of study and
experience, I felt that I came to understand the concept. I wish I could
explain it all to the reader in this simple article, but I can't. What I
can do is present one small aspect of trading from a probability
standpoint, to add to the trader's knowledge base and assist them in their own
quest to find understanding with regard to this crucial topic. I can't
overemphasize how important I think it is to understand trading from a
probability (not a certainty) standpoint.
Let me start out by going directly to what I
consider one of the biggest myths in trading, the myth of feeling the need to
'predict' the market. You can find endless numbers of market services and
newsletters whose main feature is to make predictions on what a given market is
going to do. If the writer happens to hit a few predictions, especially if they
are noteworthy (such as a fairly significant correction or crash), they may get
such a reputation as to be 'set for life'. They may have an endless string of
followers for as long as they care to produce predictions.
Now, what have they
done? They've made a claim about what the market is going to do at a point in
the future. I don't necessarily have a problem with that, per se. What I have a
problem with is in how this is used (or actually not used) as part of a
complete, comprehensive 'Trading Plan'. Remember that the Kane Trading
philosophy strongly emphasizes the complete 'Trading Plan'. Without
context, I feel that you have nothing.
Let's look at a fictitious example.
Let's assume, for the sake of this example, that after having done some
extensive studying I have found a setup that I feel gives me an 'edge'. This
amounts to a particular way that I set up some parameters that point to a
potential trade area (PTA) for me. It may be a particular way that I form a
grouping, or a pattern trade of some kind, or whatever. The specifics are not
important to this example.
Let's also say that from extensive study I also believe
that the trade, if triggered using one of my entry techniques, 'works out'
between 30% and 50% of the time. The percentage range on how often it 'works'
may be due to different markets or variations on the parameters, let's say.
I've determined that even with a 30% success rate, overall I would still make
money. I would still have a net profit (that is, overall 'make money') because
I have a comprehensive 'Trading Plan', money management aspects in place, entry
techniques, exit plans, a favorable reward/risk ratio, and so on.
In my experience it
is not uncommon for winning directional traders to have net winning percentages
in the 30%-50% range. So, let's say I've got a plan that wins only 30% of the
time, but I'm making money overall, and I'm happy with the plan. Now I need to
point out that there was a little subtlety that I slipped by the reader in the
description of this example so far. Notice that I said: "… I also believe
that the trade, if triggered using one of my entry techniques, 'works
out' between 30% and 50% of the time." I added the italics to point out what I
slipped by the reader.
This plan 'works out' 30%-50% of the time, based on my studies,
when it's triggered by one of my entry signals. This is a critical part
of what is going on here. Let me explain. What if I determined, from my
studies, that nine out of ten times when the potential trade area using this
setup is approached, the issue just goes right through it without any kind of
entry signal. Would I care? No, excepting for the fact that I would have to
watch a lot more potential trades before I got a signal to make an
actual trade.
If I had a working plan that hit 30% of the time and made me money,
that's all I care about. If I have to watch nine setups not trigger to get to
the one that does, that's no problem for me. Now bear with me, as this does
have a point. If I made a prediction and said: "When ABC Company gets to this
area, buy it." what would be my success rate? Well, 90% of the time it would
crash through the potential trade area with no entry signal, and of the
remaining 10% of the time (when an entry trigger did signal a go ahead), only
30% of those 'worked'.
By simple math, this means that overall 3% of the time you got a
'winner'. So only 3% of the time when I point to this area does it do 'what I
want it to do', and yet I'm making money. That's a laugh, to me. I'm laughing
all the way to the bank. I'm making money when this issue doesn't 'work' 97% of
the time with this setup? The answer is yes. Let's review this.
Remember, I
qualified my trade by saying that if it gets to my potential trade area,
and then it gives me an entry trigger based on my 'Trading Plan', only
then am I looking to make a trade. I have no idea what will
happen when the issue gets to a certain area. I do know that in the context of
my overall plan (which has a very large set of parameters, from entry
techniques to potential trade areas, from initial stop losses to exit
strategies, from initial risk to possible hedging strategies, and on and on it
goes), the potential trade area is adequate for the plan to make money.
Every last one of
these parameters goes into the final equation that determines if the plan is an
overall 'net positive outcome' plan. In this example the area that I watch only
produced the desired result 3% of the time, but the plan made money. Boy, what
a great market caller and market timer I am. You don't need to 'call the
market' to make money. I believe that you need to have a comprehensive 'Trading
Plan' that covers every aspect of trading as a business.
One of those
aspects, in my opinion, is the potential trade area (PTA). This comes right
from my free article Kane Trading on: The Critical
Elements of a Trade. I believe that you need to determine how you will
choose your potential trade area, and it needs to give you an edge. In a sense,
the potential trade area is a little bit like a 'market call', in that you
expect something to happen there. The difference is that a 'market caller'
needs his 'prediction' to be correct a very high percentage of the time to keep
his following.
The market caller needs his calls to be good enough to overcome the
fact that many of his followers don't have comprehensive trading plans, and
don't want to do the work to develop such plans. Now, even if I feel
that this level of market calling is unrealistic, maybe this market caller can
do it.
There may be some uncanny market callers out there. But to me this
is only a very, very small part of trading. By emphasizing the 'market call'
and focusing on predicting an uncertain event instead of understanding the
probabilistic nature of uncertain events, you are taking a lot of your focus
away from the very comprehensive and diversified aspects of trading.
I spend some
time on the potential trade area, but only in balance with all the other
aspects of the 'Trading Plan'. It's only one part of the 'Trading Plan', and
not more than an equal part in my opinion. I don't care about how many times I
don't get a trigger. I don't care if only 3% of the time that I watch a setup I
get a 'winner'. With most of the setups I'm not getting in a trade. I'm not
losing on 97% of the trades in this example; instead it's that I'm not
getting winners on 97% of the trades. Most of the time I'm just standing
aside.
Look
at it this way. What if you could trade one of these two scenarios? The first
scenario gives you an 80% chance to win. One of the top gurus is going to lay
out one of his best market calls. The reward/risk ratio is 1.5 to 1. If you
look at many of the 'profit targets' from a lot of these gurus, you will see
that 1.5 to 1 is very common. (I'm not saying that I think this scenario is
remotely possible on a consistent basis, I'm just saying let's look at what I
think is a near best case scenario for the 'guru').
In the second scenario you will
have to sit waiting through twenty different potential trade areas on twenty
different issues before you get an entry trigger. In other words, you see
nineteen setups go by and you aren't triggered to do anything. You finally get
a trigger on number twenty, and the trade has a 50% chance of winning. The
reward/risk ratio is 3 to 1. The greater reward/risk ratio than the guru's
trade is due to the fact that you have found that by passing so many trades
waiting for an entry trigger, and with the percentage of winners so much less,
that reward/ risk scenario was possible.
Which do you trade? Let me assess the second
scenario, and see if I can 'talk you into' the guru. In the second scenario you
trade once in twenty observations of the 'market call', and win only half of
those plays that you do get in. That means a full 97.5% of the time the
'market call' will not be so much 'wrong' as it will not be 'right'. You'll be
sitting around quite a bit. And when you finally do trade, you'll lose money a
full one-half of the time. I think the 'guru' is the way to go.
Now, let's look at
the 'guru'. As soon as you get his call and the market hits his area, you open
the trade. You are right in the action, trading, which is why you are doing
this in the first place. And a full 80% of the time, bang, you're making cash.
I don't see how this can't be the way to go.
Let's examine what's called the 'expected
value' of both of these scenarios. This comes from 'probability theory' in
mathematics. I won't get into the details of the calculations (although I have
written an article on this that I may post at some point); instead I'll just
show the results. The guru's technique has an expected value of 1.0. That means
that over time, on average you will make one dollar for every dollar that you
risk.
So,
what is the expected value for the second scenario? 1.0! Wait, you mean to say
that the second scenario has the potential trade area not responding in the way
that I 'expect' 97.5% of the time, and I make the same exact amount, on
average, as the 80% correct guru? Yep, that's the mathematical truth. Now
keeping in mind that this is a made-up example, and that I'm in no way saying
that either scenario is a realistic portrayal or expectation of a trader's
actual potential returns, what might this tell me?
It points out that a comprehensive
plan that has what seems like almost no ability to 'predict' the market can do
as good as the fictional guru who can hit it 80% of the time with a solid 1.5
to 1 reward/risk ratio. And the trader is able to make his or her own decisions
and plan his or her own trades, without depending on others. Not to mention
that I don't believe such gurus exist in the first place (at least not
consistently, over the long run).
Before moving on, let me clarify a few points here. It
is because of things like I have just pointed out that I have chosen here at
Kane Trading to focus on education and not on making 'market calls'. I am
trying to teach how to develop, through hard work, a comprehensive 'Trading
Plan'. It is important to be able to develop your own potential trade areas,
but I don't feel that this should be overemphasized.
Think of it like the lesson my
fellow classmates and I were taught by 'coach' in the high school weight room.
He told us how important it was to not train the upper body hard and skip the
legs, until you looked like a monster on top, balanced on a skinny little pair
of 'sparrow legs' ('coach' had his own way of getting a point across). I often
think of this when I review my own 'Trading Plan'. Put time into the potential
trade area, but not to the exclusion of the rest of the plan.
The other point
that I want to emphasize, again, is that I am not saying do not
subscribe to any services or do not listen to anyone who 'makes calls'. I am
all in favor of services that help locate potential trade areas and patterns,
as long as you know the patterns and the why behind the calls, and that the
potential trade areas line up with your 'Trading Plan'. A service that does the
legwork for you in finding potential trade areas can be very helpful. I just
want to point out that I, personally, find no use for trading services
outside of this context.
I think it should be clear to the reader by now that
what I am trying to get across is that it isn't that critical to try to predict
an uncertain event such as what the market is going to do in the future to be a
successful trader. Determining a potential trade area has its place in the
'Trading Plan', but only in the context of the entire plan. As I say so many
times in so many of my writings, without context you have nothing. I just don't
feel that successful probabilistic trading requires making high percentage
market predictions without the context of entry techniques, management plans,
exit strategies, and so on.
I think it comes down to this. There is,
literally, an almost endless string of people watching the markets. Many are
brilliant, and have lots of resources and computer power behind them. There is
so much computer-generated arbitrage going on every second that it boggles the
mind. The last time I checked the program trading average on the NYSE was 42%.
Yes, forty-two percent of all the trades were program trades!
I feel that if
anyone discovered a way to 'predict' the market to a very high degree, in other
words to a degree significantly greater than a 'small edge', the program
traders, 'hedgies', and all the rest would pound that edge into line and it
would disappear. That's why I believe that if you find such an edge it will
soon be gone.
So, why do I whole-heartedly believe that it is possible to be a
professional trader (if I'm willing to do the work)? Because I believe an
'edge' can be developed in every aspect of trading, not just the 'market call'.
I try to develop an 'edge' in my entry techniques, in my management, in my
potential trade area, and everywhere else in my 'Trading Plan'. I feel that
this will lead to long-term professional trading success.
I don't believe
that long-term success can be had by 'souping up' one aspect of the 'Trading
Plan' and being very poor in all the other aspects. (To a great extent I feel
that this is what happened in the bubble bull market, where many traders were
short-term successful because they had a strong 'edge' in predicting the market
direction (up!), but that was all they had. When the 'edge' disappeared, they
had nothing left to work with as far as a 'Trading Plan'.)
I seek a slight
'edge' in every aspect of my 'Trading Plan', including my potential trade area.
But when I point out a potential trade area that I am watching to other traders
I never say: 'When it hits this PTA, go for it.' I have no idea what
will happen at that PTA. And even if I think this PTA gives me an 'edge', I
feel that 'edge' exists only in the context of my overall 'Trading
'Plan'. If I tweak just one thing with my plan, my plan may become a net
negative expectation plan.
I just can't see the sense to tell another person, whose
'Trading Plan' you know nothing about, whose entry and exit strategies you
don't know, whose reward/risk parameters are unknown to you, and so on, that
they should buy or sell when the market gets to a certain point. I just don't
understand the logic to that. Don't get me wrong, though; I have no problem
with a service that points out potential trade areas, as long as the reader
knows why the area is considered a potential trade area.
If it's a pattern,
or a grouping, or whatever, that's fine. These services can help reduce
scanning time by pointing out potential trades for a reader to then do their
own analysis on. Some of these services that are run by real traders can help a
trader find outstanding potential trade areas. Where I have trouble is with
claims of high percentages of winners, and focusing only on the market call.
When I point out a potential trade area from my own trading analysis, it should
always be clear that this potential trade area is set up for me, and my
'Trading Plan'. It's never a 'market call'.
I hope my point is clear. Realistically, I
have very few setups where I have to wait through nineteen tries before I get
an entry trigger. I used such an extreme example to point out how deceptive I
feel it can be to think that you must predict future market events with a high
degree of accuracy in order to make money as a trader. I feel it is important
to realize that the market is uncertain, and the best you can do is accept that
you will never know with certainty what it will do at any given time. But I
don't feel that I need to know to have a 'net positive outcome' 'Trading
Plan'.
What
I need to do is carefully choose and then improve every aspect of my 'Trading
Plan' until I do have that 'net positive outcome' plan. One of those aspects is
in finding potential trade areas where I feel I have an edge. I do this with
Fibonacci groupings, patterns, and a host of other techniques.
I don't get carried
away, though, thinking that my techniques, with respect to the PTA, must 'work'
a very high percentage of the time. Or that the potential trade area can stand
alone, without context, to the point that I could tell another person (whose
'Trading Plan' I don't know anything about) what will happen when the market
gets to the area. I feel it's important to keep potential trade areas in their
proper perspective.
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