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.

14 comments:

Anonymous said...

Excellent post! Money and risk management is an important key to successful trading.
Doug in ATL

Mike said...

the beast....

monthly SPX from Jan '95 to present.

Nice post.

-Mike

ROB G said...

smiddywesson
i know how important it is to manage risk and use money management, but how does one learn these techniques. i asked this question 2 weeks ago on this board and someone told me to read high probabilty trading chapter 9. well i got the book but still dont understand the best way to use stops. it says there are percentage , money and time stops. if i just trade equities what do you think the best stop is to use? i understand i have to place stops below the normal market movement in a security but how does one tell what that is? i have been investing for years but realize buy and hold is dead and want to be a better trader. i subscribe to market club and just started using there triangles but feel im getting shaken out of trades that eventualy start to work. any thought are much appreciated.

rob g

Allan said...

Rob: If you are using Market Club's Triangles, you have an automatic built-in stop with the Triangle logic. If that is too far a stop for you, my suggestion os to drill down one time frame at a time to find a more comfortable stop. Thus if you are using Weekly signals to enter, use Daily signals for exits and re-entries. You can do this on intraday time frames as well, although as of now, Market Club doesn't have those automatic intraday triangles, you have to manually apply a "three-period high/low" threshold for whatever time frame you would like as your stop generator.

In all my years of system trading, I have found that stops degrade performance, without exception. That is one reason I tend to gravitate toward trading systems that are designed around built-in stop/reverse levels so that the underlying logic of the methodology is your reason for exiting, not an arbitrary risk management level.

Anonymous said...

Boy was that a long and useless post. I wish I had those 5 minutes of my life back.

-Kick

Anonymous said...

Kick, do you donate to Allan's blog ???

Mike said...

excellent info Allan.

thanks for posting.

let the tool do the work....

-Mike

Anonymous said...

Kick: you have made it clear that this blog and methods discussed here are worthless to you. So you made a conscious effort to come here, read the post and waste your 5 minutes. They were your 5 minutes...own something or your actions.

abot said...

"In all my years of system trading, I have found that stops degrade performance, without exception. That is one reason I tend to gravitate toward trading systems that are designed around built-in stop/reverse levels so that the underlying logic of the methodology is your reason for exiting, not an arbitrary risk management level. "

Nicee!

Anonymous said...

My shorts get lit up like a Christmas tree ...

I have to take off my shorts if it gets any hotter ...

violinbf said...

what is going on with NNVC allan? where is the pr? the stock price continues to decline. are you holding?

Anonymous said...

are we flipping back to buy yet ???

PENN STATE Eric said...

Kick:

Your father should have 'pulled out' of the dog earlier.

charles said...

RE: Your response to the MarketClub question.

I also am a user of marketclub and I was curious as to what exactly you meant by "automatic built-in stop with the Triangle logic." Do you mean waiting for a daily/weekly/monthly red triangle? If so, which one? I am also somewhat confused as to how I should technically evaluate the triangles to determine the stops I should put in prior to entering the trade.

I know you aren't paid by MarketClub to do customer service, but you seem like a nice dude, so I figured it was worth a shot for a newbie to ask a question of a veteran.

Thanks,

Charles