Likely. Maybe. Probably. Market analysis is filled with such words. What do these mean? We will answer that with another question. Suppose you buy a stock which has just cleared its previous peak and is showing no signs of slowing down. What are you really buying? Or, as is germane to traders like us, suppose you buy a stock that has been repeatedly finding support at its 20 daily moving average (DMA) at 1% above its 20DMA. What is it that you have really bought?
If the answer to the last two questions is "I've bought the stock, stupid!" then you may be right but you are missing the point. What you have actually done is bought a probability. A probability that the price of your stock will move up. And the basis for the assumption is that market has since time immemorial tended to eventually move stock prices towards their fair value. And so long as there is demand for the stock to support this hypothesis, there is no reason for the market to act differently just to spite you.
Not so 50:50
So the name of the game, friends and neighbors, is to get the probabilities right. It now all boils down to spotting the right probability on the right stock, and the rest can be as easy as hitting a wall at three paces.
As speculators, almost 90% of our success depend on getting the odds right. Trading only when the odds favour the trade is the single most important difference between a speculator and a gambler. We predominantly use technical analysis (TA) to find the right odds for a tradeable move.
We use TA to identify tradeable trends but what we are buying is only a probability. (And you thought all along that we bought stocks! J) Which is why it is so important to define the upside and acceptable downside. This we do by setting profit targets and stop loss levels.
Given that a tick (which is the movement in a stock price from a single trade) is positive, the probability of the next tick also being positive is 50:50. But the trades we recommend do not work tick by tick. These instead take a view on what the trend is likely to be several days later.
Obviously, the odds change as time goes by and a trend sets in. And once a trend is in place, the odds of the trend continuing are much larger than the odds of it reversing. Equally obvious is the fact that a 50:50 probability that applied from tick to tick is no longer valid.
Bring out the crystal ball
You will agree that dreams of a farmhouse in the hills with a temperature-controlled swimming pool are realised by trading BIG moves. Unfortunately, you have no way of predicting the odds of these big moves.
To quote the Worden brothers, one of the more successful traders of our time, "In the business of stock trading, prediction has to be used pretty sparingly -- mainly because the future is so stubborn about revealing itself. Prediction is a trader's euphemism for wishful thinking, if not delusions of grandeur." J
Sweet dreams are made of these
Small moves however are much easier to predict. Because in predicting a small move you are essentially playing a probability rather than a price forecast. And every trade starts off as an attempt to get a foothold into the stock which has a reasonable probability of trending in the short term.
Having done this, you watch the changing odds very closely to see if you have to change your mind. The point at which the odds start to look shaky is where one would set a stop loss. The stop loss now works as the level at which the immediate probability of the price moving to your favour reverses.
This also explains why stocks sometimes manage to move in the direction of your original call after stopping you out in the first move. Because, while the immediate probabilities are against you, the stock some times builds a larger longer-term probability of a trend in the direction of your original call. But again, there is no certainty that this may happen always.
Foot in the mouth?
Having got your foot into the trade, you wait till the position starts to draw out profits. And as the stock continues to trend strongly, by moving stronger probabilities in its favour, you stay on the trade for the big moves. This is the way all big moves are traded.
Once the stock starts behaving the way you want it to, you keep tinkering with your profit targets and stop loss levels to protect most of the profits. This way you will be able to get the most of what the market wants to give you.
The Worden Brothers liken the initiation of every trade to taking a little trip in the right direction. They go on to say, "If you can be right about the trip (the trade) and the stock is still strong, you may decide to stay for the journey. It is like taking a car trip. You feel your way. You handle the curves on the road as you come to them." But there is no way of predicting the long road you will be travelling before you start the journey.
Such large moves come very rarely. And you never know them in advance. Most trades fizzle out early. This is where the rationale of using stop losses can be most appreciated. If you manage to break even or take small profits or losses on most of the trades, and use the same techniques to ride the big ones, then these big trades will make up for all the small losses and 'maybe', it is 'likely' that 'probably' there might be enough gravy leftover for you to keep those dreams of a farm house alive. J
May the road rise to meet your step!
No comments:
Post a Comment