Friday, October 23, 2015

Traders Must Certainly Understand Uncertainty


From Our October 2015 E-mail Archives: One of our traders asked how much weight to give to other elements of the markets. Our Head Trader, Robb, replied with his thoughts based on nearly two decades of trading experience.*


-----Original Message-----

From: Mark G.
Subject: Quick Question If You Have A Moment

Hi Robb,

Mark here – one of you junior traders. One of the struggles I've had this year deals with correlating data (not sure if that's the right term).

For example, everything on the chart for the S&P 500 Index ETF (SPY) right now is telling me to go long. My weekly and daily charts have broken key levels, plus my weekly and daily moving averages that I look at have either broken or are about to break key levels. If this were just an ordinary stock called "XYZ", then I'd be going long.

What stops me is not the chart itself, but the fact that it's an index and shouldn't other elements of the market (like bonds, gold, etc.) be behaving in a certain way?

I needed to balance out my portfolio with some longs, but i didn't pull the trigger on some setups because I saw things like the bond markets going higher as we were approaching new highs, which signaled to me stocks going down – which didn't happen.

How much credence should I (or rather, do you) put in other elements of the market when determining your outlook or your decision to enter long or short positions?

Mark


-----Reply Message-----

Hi Mark,

Thanks for the email. I think your question is a great one and the answer is not a short one.

When you go out and perform your research, you will inevitably find conflicting data, which leads to confusion and uncertainty. The first thing you need to understand is that THERE IS NEVER CERTAINTY!

One of the biggest problems that I have seen in all of my years in this business (and working with tons of traders) is that many traders who are left-brainers (i.e., analytical) often try to fit the market into boxes and categories where the outcome is certain.

For example, in engineers' minds, if the process is correct and everything is hooked together correctly, then the desired result will ALWAYS happen. When it doesn't work, then they believe that there is something wrong or missing in the process. They also believe that once they figure that out, then they will achieve the desired results.

Now, this is how most things in life work....except trading. Ha! Just kidding.

To have the correct outlook, you need to think more like a poker player than an engineer; that is, you need to understand that it's all about odds and there is never certainty. As a poker player, you aren't consumed about winning every hand. Rather, you are concerned about only playing hands that have high win/loss ratios, fully knowing that even with an AA (ace, ace) in your hand, you will still lose 71% of the time if playing with 6 people. Before taking a bet, successful poker players wait until they get the right hand at the right position on the table against the right players.

As traders, we need to think the same way. We are not trying to predict what will happen in the future. That's a fool's game and never works. We need to think like the poker player and think about odds and risk/reward. The first thing that we need to do is build a system (trading plan) that outlines the exact things/correlations that have to happen before you take action. The more inputs that you put into your plan, the less setups that will trigger since there becomes conflicting data. Whenever you have conflicting data, it doesn't match the setup criteria and the trade can't be taken. At Maverick Trading, we like a more simple trading plan/system that is accurate and timely and much easier to use/navigate.

To answer your question, I think you are throwing in way too many inputs into what you are looking for in a trade setup. If you go out to the markets and research and score everything, then you will almost always be confused. In the rare time everything does match up, then it's highly likely that your stock/market is in the last gasp of a trend and there is a major trend reversal in store. That's what I've found in my life in the markets. Once everything gives you the green light you were waiting for, the trend is likely over.

I recommend that you first go back to your trading plan or implement new inputs into your analysis and ignore everything else. In your example, you mentioned the SPY on the daily chart is bullish, but the weekly and monthly charts look kind of bearish. Your time frame will determine which inputs you want to use.

For example, my trades usually last 2-3 weeks, so I am not too concerned with weekly or monthly charts. All my analysis needs to be done on the time frame that matches my desired trade length. If I have a 2-week trade, then I don't care what happens to it next month. All that matters is that 2-week time frame.

Secondly, you need to choose which other markets you will use as inputs and ignore the rest. I personally think that both gold and oil don't correlate well with equity prices, but I do think that bond prices have correlation worth watching. However, there will be periods of time where the gold and oil markets will have much greater correlations on equity prices than the bonds do. Now, if I am using bonds and you are using gold, then sometimes your inputs will be more accurate than mine. However, over a few years there really isn't much difference as long as we stay consistent.

To sum it all up, figure out what your inputs are going to be for your checklist/setups and ignore everything else. Then, follow them religiously. Understanding your inputs will work better in some markets and not so much in other markets. I know we would all love to perfectly pick and choose which indicators will work in the present market conditions, but that is pure fantasy. Consistency is the key to this business and is FAR more important than the gold market's correlation on equities.

Hope this helps,

Robb

* NOTE: Some original wording has been modified for legibility.