Introduction to the Stock Market_2. Can stock charts predict the future_ Trading Systems

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.