Wednesday, June 24, 2009
Tracking the Invisible Man
Guest Blogger: Smiddywesson
We have all heard the parable about the three blind men who try to identify an elephant. The first one grasped the tail and claimed it was a stork. The second held the trunk and thought it was snake. And the third one hugged its leg and thought it was a tree. All three men were wrong because they failed to recognize the limitations of how they were “viewing“ the beast. Unfortunately, we are faced with a greater task than the three blind men, and are therefore even more blind than they. The beast we are trying to see is huge, amorphous, and non corporeal. The beast you can’t see it, smell, taste, or touch, is the market, and yet we believe we know it. We view the market through our indicators, but most of us fail to recognize that those indicators are as limited as our sense of touch in their scope. They can describe what the market is in some limited fashion, and they can tell you where it has been, but they can’t show you the market directly, and they can’t tell you with any degree of certitude where it is going.
The market is an invisible man that we traders track across a snowy field. Deaf, dumb and devoid of any sense of touch or smell, we methodically follow our quarry’s footsteps, hoping that our indicators will make some sense of who he is, and where he is going. Unfortunately, tracking a real market is even harder. The invisible man could be expected to maneuver around obstacles, like a fence or a tree. However, the market operates in a fog of war where even the obstacles are invisible. We can see the obstacles that can move a market far off in the distance, like deficit spending or the specter of inflation, but once they draw near into the fog bank, we can’t say when they will alter the path of the market. After the fact, we can guess like CNBC what moved the market, but we never really know the causes for sure.
The good news is you don’t need to have remarkable powers of prediction to catch the invisible man, you just have to survive long enough to trap him. There are a thousand ways to win in the market, and you only have to be an expert in one of them. This goal is achieved by identifying where profits come from. If your average win, multiplied by your percentage of wins, outweighs your average loss, times your percentage of losses, than you have found your edge. Successful traders use this formula to evaluate their systems. Those systems don’t have to be perfect, they merely have to have an exploitable edge. In fact, successful traders sometimes boast that they could trade profitably over the long run using only a coin flip to determine entries. Now a coin only has a 50% chance of landing favorably, but these traders know they will win that boast because they are aware that the flip of the coin is a small part of their profits. The majority of their success or failure rests with their risk and money management. Profits depend upon controlling the size of their wins and losses (something in your control) rather than some special indicator or system delivering an incrementally higher percentage of wins (a goal whose pursuit delivers diminishing returns). In short, for most successful traders, the equation is dominated by the size of the wins and loses more than the percentage of wins and losses. Successful traders know you don’t need a holy grail to win. Similarly, you don’t need to find the perfect indicator to trade profitably. In fact, profitable traders often repeat the mantra that they keep their indicators to a minimum and keep their trading simple.
As I have said, there are a thousand ways to win in the market, and you only have to be an expert in one of them to win. However, I offer a caution to my fellow traders that the inverse is also true. There are also a thousand ways to lose in the market too, but on the down side, you have to be intimately familiar with each and every one of them in order not to lose.
There are hidden dangers in tracking an invisible quarry. Some types of price action, like when the market moves after a big economic announcement, are easily explainable. But the reasons for price action are not always clear. I’m not even sure there always has to be a reason. If the market reflects the actions of living beings, then shouldn’t it have some movements that are purposeful and some which are autonomic? Maybe the market is doing something and maybe it is just scratching its butt. Through our limited trader’s lenses, we can quantify all of our quarry’s behavior, but we can’t really sort out the different categories of market behavior due to our inability to observe the elephant directly. Some day, there may be dozens of alternate wave counts yielding very precise interpretations of price action based on the recognized categories of market behavior. Until then, kidding yourself that you are not mostly blind to the market, believing that systems and indicators are more important than money management and risk management, will remain on of the most common of those thousand ways to fail.