Wednesday, June 05, 2013

Trading the odds

I always try to simplify things down to their lowest common denominator. Not only does it crystallise things in my own mind, but helps when discussing aspects of my own trading approach with other traders. On that basis, I am a definite advocate of the KISS principle. As an example, I've set out below my reasoning on why I prefer to follow a trend signal, rather than predict future price movement.

When thinking about a stock, commodity or other instrument, price can do one of three things - move up, move down, or move sideways. Therefore, when entering a new position on a totally random basis, you have a 1 in 3 chance of being proven correct.

Studies have been carried out on price movements in equities, which I have referred to in my e-book. They support the theory that, when a new trend starts, that trend will tend to persist. This works on both upward and downward trends. Of course, no-one knows how long (both in terms of time and price) that trend will last for. But, on that basis, when a new signal is given, the trend will either develop, or will fail. As a result, the odds have improved from 1 in 3, to 1 in 2.

I therefore wait for a possible new trend to be signalled before entering any new positions.

More importantly, I only ever exit a position when that trend has extinguished itself. I do not want to potentially close a position too early, thereby missing out on profits for no good reason. If a trend tends to persist, why would I want to cut it short? I have put the law of probabilities on my side. This is also why pure trend followers always avoid picking tops and bottoms in a market, and do not exit existing positions using oscillators to determine whether something is overbought or oversold.

The trick is to know what constitutes a new trend, or the end of an old one. That will depend on timeframe and the parameters you decide to use. As I have mentioned in previous posts, there can be a number of trends in existence at any time, depending on what your preferred timeframe is.

In my own case, I use my scans to give me a signal that a potential new trend may be underway in a stock, and I try to jump into a position as early as possible, thereby maximising the potential reward:risk ratio. Of course, not all the signals work. Historically I am only proven right 50% of the time - but that is why you use prudent risk control to minimise your losses when you are proven wrong.

By also ignoring stocks where there is no apparent trend, I have also avoided unnecessarily tying up my capital in a non-performing position. I only want my capital to remain in a stock that is trending in my favour. Which is another reason to cut losses quickly, and let profits run.

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