Lesson 2: Can stock charts predict the future? Trading Systems How can you predict the future, when the only thing you know is the past? Can past data predict the future? Can chance predict the future? I’m going to answer this question with a small case study so we can understand this better. First of all, let’s answer the theoretical part of this question. Why predicting is a problem ● The future is uncertain No matter how good our analysis is, it is only as good as the information that is available right now. We cannot know for certain what will happen tomorrow. Analysis in regards to likely movements in the future is done with the idea of "all else being equal". This means that we assume a stock will go up based on a trend, if things remain as they are right now. ● We can't predict all contingencies While on some days, in fact many days, everything does remain equal, there are always days, weeks, months or even years that defy the odds. It is during these times when predicting can be especially dangerous if we are wrong in the prediction. Predicting something will go up when prices are falling can cripple a trader's finances, especially since we can't know for sure how the market will react to further news or information that may become available. When prices are falling even good news may not push prices substantially higher, and when prices are rising even bad news won't necessarily have a long-term negative effect on price. ● If the overall market moves higher, this does not mean a stock will also move higher Often analysis for individual securities is based on the sentiment of the overall market. This can mean a trader expects one stock to rise because the market is rising, or vice versa. This does not always occur, especially on shorter time frames. Unfortunately, an alternative scenario also occurs where a trader expects one stock to outperform while the rest of the market continues to fall. Traders must be aware of market dynamics as well as individual stock dynamics. Either way, the end result is that we want to be trading in the direction of current cash flows, not against them, whether it be in the overall market or individual securities. ● Predicting a particular share should move higher is vague and the investment decision will rarely include a profit or stop-loss exit point
While not always the case, inexperienced traders predict that their equity positions will rise and assume that they will be able to get out near the top if they are correct. In reality, such a vague plan will rarely work out. Therefore, all traders must have a plan for how they will enter and exit a trade, whether the trade results in a profit or a loss. ● The holding time from stocks has decreased along with increasing volatility Stock market volatility has increased over the years while the holding period for securities has fallen off. Buying and holding is still a viable strategy if the method is well devised (as with any trading method) but due to limited capital, buy-and-hold investors must be aware that volatility can reach very high levels and must be prepared to wait out such periods. Active traders trading on shorter time frames should trade in the direction of price movements given that volatility has increased and even short-term moves can sustain overbought or oversold levels for extended periods of time. ● Statistically, prices rarely move in straight lines for long Predictions are often based on strong emotional feelings - the stronger the feeling, the stronger the trader may expect the price reaction to be. Thus, the trader assumes the stock will fly in their direction in a straight movement, leading to a home-run trade. When we look at all the securities in the world and then factor in time variables, having a position right before a major move is very unlikely, statistically speaking. Traders are far better off trading the averages and trading in the direction of price movements to gain profits, as opposed to looking for one trade or stock that rises aggressively in their favor in a short period of time. Buy high and sell higher. Find out if you could surf these risky waters. Alternatives to prediction The premise of this question is fundamentally wrong. You don’t need to predict the market in order to make profits. What you do need is a system which you’ve tested properly, add a dash of money management, and you’ve got the recipe to be a profitable trader. Traders use historical prices, as we’ve seen, over many years, analyze it (quantitative analysis), and try to decipher a commonly recurring pattern. This helps us identify something that keeps happening. Case study The theory part is over. We will discuss now an interesting case study.
Let’s suppose you are great at trading the symmetrical triangle. For those who don’t know what this is, it’s basically the price converging toward a central point. It is grouped under continuation patterns. Here is what it looks like: This is an example of a symmetrical triangle in an uptrend. As a general rule of thumb, when markets are moving up, the symmetrical triangle will continue the trend and break upwards, and in a downtrend (when stocks are falling), it will fall, and the markets will continue to fall down. Now let’s say you decide to make a system out of this. You need three things: 1. A time frame. Let’s suppose you decide to trade the 15-minute charts. 2. A method/setup. Let’s suppose our method is just trading the symmetrical triangles, breakouts and breakdowns, according to the trend. 3. A stock list. It’s impossible to trade all 3,000 stocks of the Nasdaq index, so let’s take 5 stocks that we scan every day and trade this pattern. The next step is something that we call backtesting. So we will take these conditions, run them through two or three years of data, and see if we can observe anything. Let’s suppose you do this, and 70% of the time, the stock moves 2% in your favor. Now we’ve got something very interesting to play with. All we need to do now is manage our method. Because the main thing about trading is not the method, but money management, and specifically: - Preserving capital - Managing risk This is how you make money trading stocks.
So 70% of the time, the stocks move in your favor, and 30% of the time, they move sideways or fall down. Out of 10 trades, 7 trades are profits. These profits are 2%. 7x2%=14%. That’s our profit. 3 trades are losses, so if you can limit this loss to not more than 1 percent, you have yourself a recipe for success. 3x1%=-3%. That’s our loss. Your net gain is 11%. This is why you don’t need to predict the market; you need to follow a system that’s tested thoroughly, manage your risk, and make sure your losses are smaller than your profits. This is the real holy grail of the stock market. This is how you make money.