The Nature of Trading
Traders forecast future price using some combination of fundamentals, indicators, patterns and experience in the expectation that recent price patterns forecast the probable future often enough to make a profit. The trader's problem is that nothing that has happened in the past or that is shown on his indicators is any guarantee that future prices will go in the direction and amount needed for a profit. The profitability of each trade has some randomness and uncertainty. This is a realm that many are not equipped to deal with. We do not know what to expect from random processes and are not innately equipped to deal with the psychology of trading.
This Web site is not about how to trade - there are no price charts here. There are many books on this aspect of trading. This site is an exploration of the kinds of trading results and patterns that make profits likely - or unlikely.
The real world - a surprising place
At a casual glance, trading seems easy. One trader's mother looked at a price chart and, pointing to low and high prices on the chart said, "What's so hard about trading. You just buy here and sell there." Trading is so obvious looking back at a historical chart. It is easy to see the trends, the highs and lows. But when faced with the hard right edge of the chart, it is not so simple. Trading is looking back at what has happened in order to predict what might happen next. However the future will never be precisely known in advance. One bit of news or another trader with a different opinion and more capital, can make your next trade take an unexpected turn.
Trading is dealing to some extent with random outcomes from each trade. What a good trader does is bias those outcomes in his favor.
Trading is not a sure thing. It is a probability exercise. Traders talk about having an edge, which is simply a higher probability of one outcome than of another. To succeed you need probability on your side. You need an edge. Mark Douglas in his excellent book "Trading in the Zone" says the following.
There is a random distribution between wins and losses for any given set of variables that define an edge. In other words, based on the past performance of your edge, you may know that out of the next 20 trades, 12 will be winners and 8 will be losers. What you don't know is the sequence of wins and losses or how much money the market is going to make available on the winning trades. This truth makes trading a probability or numbers game. When you really believe that trading is simply a probability game, concepts like "right and wrong" or "win and lose" no longer have the same significance. As a result, your expectations will be in harmony with the possibilities.
(Mark Douglas: "Trading in the Zone: Master the Market with Confidence, Discipline and a Winning Attitude." New York Institute of Finance: New York, pp 130-131).
As traders we use past patterns to forecast the future. Forecast it not in the sense of certainty, but in the sense that we know the likely future direction of the market we are trading. There is no certainty about the direction or the magnitude of the move. However we can be certain that in the past when the patterns, fundamentals or indicators have been as they are now, then probability is in our favor. We have an edge.
Victor Sperandeo studies the markets he trades in great detail looking at economic conditions, political climate and historical statistics. In 'Trader Vic II' is a table of the extent and duration of bull market corrections from 1896 to 1991. This is one example of how successful traders strive to put the odds in their favor. (Victor Sperandeo, "Trader Vic II" John Wiley & Sons, 1994 pp 131-136 )
Many books and articles about trading seem to deal mostly with entries. Exits are the next topic in popularity. The neglected subjects are probability and money management. Probability is a difficult subject for many of us and money management never gets the kind of discussion it deserves. Even the definition of money management is different depending on which book you read. There are a few authors who point to money management as the most important issue determining profitability. Many discussions of money management talk in general terms about several risk strategies. Among the strategies that are commonly mentioned are constant risk, fixed fractional risk, fixed ratio and optimal-f. There surely are others in existence or waiting to be invented.
Many of these are complicated and they only tell us what they believe is a strategy to maximize profit. They generally neglect to tell us just how risky they can be. How unnerving the drawdowns will be.
Examining randomness in trading
The central theme of this site is analyzing the variety of combinations of trading results that occur in trading. For each individual trade there is a range of possible results. These are the result of a single trade. Then as more trades are made, these individual trades occur in a sequence that increases or reduces equity. These individual trades happened in some order that gives a final equity after all trades are done. That ending equity is the ultimate measure of success. Using the same trading method in the future, we have no assurance that the individual trades will each have similar success. Even if the range of profit and loss from individual trades is like those of the past, they may combine in a different order. There may be a longer run of profitable trades or a long series of losses. Even if the previous trades are representative of what the trading method can do, those trades may combine in random fashion in the future to give different end results.
We can calculate the odds of a coin flip or a roll of dice, but for many real trading scenarios a strictly mathematical approach is not possible and our intuition is inadequate. It would be nice to describe trade results in some compact and easy mathematical formula. One tool that has been used is expectancy, which is the expected outcome of a series of events. What we will discover is that expectancy is easily misused and must be modified for the risk management strategies that are used in trading. It fact there are two types of expectancy. Even introducing a second type does not solve the problem of comparing various methods or trading. Worse than misuse is the fact that where there are a wide range of possible outcomes and a single number like expectancy cannot describe the whole population of possible results.
Although this is site not about how to trade, there are ideas here that need to be in the trader's arsenal of tools.
I expect this will help you think and trade with probability in your favor. If you have a solid edge, profit will follow. The ideas here will be stepping stones to making solid profits.
Copyright 2002, Larry Sanders
Last update 2002.04.14