This is a question that many investors (if not all) try to answer every day. In fact, if it were possible, it would be possible to make large returns in a short period of time. However, there is a theory that says no, it is not possible to predict the value of an asset on the stock market, for example. It is known as Efficient Market Theory.
This theory is based on the assumption that all available information is rapidly absorbed by the market by all of its participants and it is impossible to make significantly gains above the market average. This characteristic is the concept of efficient market (FAMA, 1970). Secondly (FAMA, 1991), there are three variants for this hypothesis of efficient markets. The first is the weak hypothesis, which considers that markets absorb only the historical information that is public available. A medium or "semi-strong" hypothesis is based on the principle that asset prices reflect this public information instantaneously. Fama further adds the strong hypothesis, saying that the market instantly reflects even the information considered as insider.
That is, the theory of efficient markets suggests that stock prices follow the Random Walk theory. It states that it is not possible to predict the future on the basis of past data (in line with the theory of efficient markets), that is, it does not mean (for example) that the stock price has increased today, yesterday, or in another period that the price will increase tomorrow as well, because the market works irrationally so the price of a stock will be unpredictable (as well as the movement of a molecule into a fluid).
Let's show in practice how this works by using a decision tree. They are a supervised learning algorithm whose output is If - Then rules that classifies a discrete set of values, given continuous or discrete value inputs. In the figure below we have a classic example of a tree that assists in the decision to play or not given certain conditions like climate and humidity.
In our example we will use a database containing the trading information of the Ibovespa index, from 14.08.2014 to 04.09.2014, every 5 minutes. The available data are Date, Time, Opening, Maximum, Minimum, Last, Volume (contracts), Volume (R$). With this data (1617 records), we created 22 variables to try to predict if, in the next 5 minutes, the index will be up or down.
We run the decision tree in free software Tanagra. After loading the base, we run a χ 2 test to select only the attributes that are really relevant. Here we have our first cut. Of the 22 variables, only 3 remain. The first is if the difference between the maximum and the opening is less than 30 points. The second is whether the volume average of the last two periods is greater than the average of the previous period. Finally, the third measures whether the maximum price of the last period is greater than the maximum of the period prior to it.
Analyzing the result of the decision tree with these three attributes, we see that the chance of knowing if the market will fall or rise in the next 5 minutes is a little bigger than playing a coin. From the confusion matrix, we see that practically the decision tree goes right or wrong at the same frequency.
Notice also the rules that were created. None of them is able to hit more than 62% of the records, with most of them close to 50%.
A curiosity is that in the stock market, a strong consensus among traders is that the traded volume is a strong trend indicator, either for high or low, since it shows that market agents are determined in relation to a specific movement. Of our 3 attributes, 2 are related to the trading volume, showing that the tree was sensitive enough to understand this behavior. Even so, our result is in line with the theory of efficient markets.
Of course, there are more complex methods to try to estimate market movement, but even so, our approach shows that it is a Herculean task that has not yet been completed. The question that remains is: is there any information that is not immediately absorbed by the market, and given this, is possible to use it to predict stocks movement?
The studies continue around the world and if someone finds out, maybe we will never know ;)
There is no better way to understand how hard is to be a trader or investor than actually start being one. Open an account with a small value and buy your first asset. Remember that the account must be small because you will break, then you can not lose something that will hurt you. Established this begining, feel the emotion flowing and hands shaking every time you push the button. Precisely because it is difficult, you should try to be a trader. This difficulty makes you start off the promises of easy, fast and astronomical gains. How many times have you read that a person Y has won more than XXXX% in a few days ... sometimes hours. Pure quackery.
I have repeated countless times and it is time to do it again: everything in life takes time, is molded with practice, with trials and mistakes. It takes a while to you really call yourself a trader. You will do this in the beginning. You will spread the word to everyone around you about how much your portfolio has grown in a week while your friends will still be in single savings accounts. One day you will lose a lot, then will be ashamed of them and everything you said, but do not not give up. So you start to be more cautious with each one f your words. A trader has born!
But if it's so hard, why should I try to be a trader?
There is a person's profile that likes to excel, to be challenged and do more of it. They like clearly to feel the reward for every act and constantly improve. Being a trader is thinking in psychology, discipline and finally strategy. Starting with psychology, you have to control your emotions before all of it. Then, when you're thinking with your head, you must have discipline (remember the post on the reward for consistency) to strictly follow all that you have learned. Finally, you have the strategy, the trading system to operate in the market. I say most people lose money because they already start in the strategy but forget to control the emotions and at the lower bump in market they are are out, settled and emotionally wounded. Then the guilty one is the market or yourself? You will see it is not so easy to buy low and sell high.
You are (or should be) responsible for your actions. We grew up listening to it and this concept is present in discussions about determinism and free will. If there is no free will, how can be there an individual responsibility?
Free will is the possibility of having the power to make a free choice. It has been discussed by science and religion and is still controversial. The deterministic thinking says that all events are caused in a necessary and sufficient way for previous events, that is, a person is deprived of freedom to decide and influence the phenomena that him/her takes part. In the other hand, libertarianism supports the view that people have free will and are the agent's actions that always produce the event. The latter concept is most commonly used in economics.
At the end of the day, we know that we are responsible for our actions. And these actions would not have been committed without free will. It was our decision. It is common today to assign the responsibility of things to others ... Outsourcing guilt corrupts you and prevents you from going futher, in life and in the market. We blame the government, a friend, the neighbor, the hole in the street, politicians and many other concrete and abstract beings, but we forget that the decision was made by ourselves. This is very hard to accept, that is way we have this tendency to outsource the guilt and responsibility. When you take your part in the error, you open the door for a new journey of knowledge to be started, once you can identify what are the most relevant factors about the error, and which are the secondary factors of error (here we can allocate the third party responsability), and try our best to prevent or avoid a repetition of this harmful action.
How being a trader help you with that?
You, as a trader, will go wrong. You will make mistakes. And also will blame the market, the big sharks, the speech of a president of the Central Bank or the "current economic environment". But it will be hard to look at yourself and remember that it was you who pushed the button. No one forced you to it. We have a natural difficulty in accepting our mistakes, and denial is a strong step in this process. Those who are released faster from the denial phase accelerate the acceptance stage that cause natural evolution as a trader and as an individual.
As many things in life, trading is not different: if you are consistent about doing something, you will have your reward in the end. Of course, this is not related in doing wrong things all the time (although it will also “rewards” you somehow). Let us say after you have decided to be a trader, you may be luck and have a great first profitable month. Ok, for sure it has a chance of you just being lucky. However, let us assume you were not and were helped by your skills as future trader. As things in life are not linear, in the following month you not had the chance to trade as you did before. What happened? Probably a non-profitable month. Then yours self-steam as trader starts going down and you are done: your emotions will take control of you.
However, in fact, what happened?
Having as premise that you have a profitable trading system, there is one thing you should care about that is the fact that your trading system for sure is not 100% accurate (as none trading system is in this planet). It will be right and wrong according to the market fluctuation. That is why you went in loss for the second month. As we do not know when your trading system will fail, you must do your trades consistently in order to be exposed in the market as much close as possible to all “right” and “wrong” entries. Then you, on average, will be right according to yours trading system average – which means profits. If you trade occasionally, you are setting the odds against you – unless your method tells you to trade occasionally.
Besides this mathematical effect of consistency, we have another point: we humans are very good classification machines. We learn with time from observations. Therefore, if you are trading frequently naturally on every new trade you will become a better trader than before. This is how life works – it is not me saying it, just observe from your experiences. Ok, it is very hard to accept this somethings – but this is what shows that you have emotional intelligence to be finally a trader. You must accept that things does not happened exactly in the time you want them to happen, so be patient (another great skill you develop from being a trader).
Right now, when I am writhing these words, I am in a position that is against me. It is not easy to be comfortable with it but I did my entry based on my trading system. There is nothing to be afraid once I know why I did the entry and when I must leave. As it is an entry based on a high probability trading – and I am doing this for quite a long time – I have the odds in my favor. In case the odds turns against me, a suitable stop loss will take place and tomorrow, I will have another chance.
After so many years, maybe I can say one thing about trading: nothing in your life will be more unpredictable than when you are staring into a chart trying to understand what will happen next. You will start to see things in your life - things you think are the hardest ones to deal - in a very different way. Then, you will fell in love with it. In case you do not, it is not a bad thing. People have different talents and maybe trading is not for you. You can see this when trading stocks. However, there is something else I would like to talk about: it is called Forex Trading.
Ok then, what is Forex?
Forex means foreign exchange rates. A currency is evaluated against another currency based upon several criteria, such as the economic situation of countries, political news, media and so many others factors. The easiest way to understand a currency is think about it is the value of that country in the same way a share represents the value of a company. Trading it means buying or selling foreign currencies. If public companies have shares that you can buy and sell on the market as you wish, then countries have currencies.
In forex, you do trades based on pairs of currencies. An example is buying EUR and selling USD. There are other major pairs made with the USD, like GBP (British pound), JPY (the Yen), CAD (the Canadian Dollar) and so many others. These ones are the pairs with the highest liquidity in the market. In addition, liquidity is another wonderful thing about forex. It is a market of 5 trillion dollars a day. By day, you should understand that Forex is a 24h trade, starting on Monday at 0:00 and ending on Friday at 23:59. During this time, you can be 100% connected to the market. Any open position you may have can be influenced for something happening during overnight.
In the Outspoken Market, we always talk about emotions on trading. That is because we believe this is the key player on trading. Especially if you think about Forex trading, it should be a sniper duty. Cold and accurate. What does it means in real life? It means that emotions should not be used as the sole foundation for your actions. A little bit of control must be exerted continuously on emotions. The two main emotions: fear and greed. In the trading world, greed is one of the two reasons people are losing money. In real world, greed is one of the two reasons people are losing their lives. The second reason is fear. Fear manifests the moment you do not enter that position because you think it will go lower or higher, or when you close a potion too soon, thinking about that the market will turn against you or will never be in your favor. Fear makes you lose money by not letting yourself taking the profits that you worked for.
One common thing about these two feelings is that both will make you staying in a losing trade and hoping for the market to turn into your favor. This is definetely the worst thing a trader can do. It will never happen. You will learn that the small loss is the first one.
Welcome to our place. Welcome to Outspoken Market!
Well, there are problems and try to bypass or avoid them only will make them become larger. This is not news to anyone, although people still insist on ignoring this fact - and yes, we all do it. That is, the zero step to solving a problem is to accept that there is one.
There are some outstanding features of the people who are natural problem solvers. We can see that they naturally take more risks, are persistent, with an open and curious mind; and not only! Being nonconformist is another key skill. There is always a way to do something and if it was not found yet, the nonconformist will not rest until they find a way. We can then say that being a risk-taker, persistent and curious will make us an incensed person.
And is that good?
The daily exercise to become a trader makes us develop these special skills to be a problem-solver more practical and effective. The first major problem of a trader is to control the emotions and know the right time to make an entry. With some exceptions, traders have good strategies, but they usually do not work because their own. Thus, the daily exercise of patience and observation during the trading is extrapolated to other areas of life, as we are inseparable beings. A familiar problem will affect your performance during a trade and vice versa. Do not ignore this fact.
Being aware of this leads us to the level of reflection. Decisions will become more meticulous, taking into account different views and perspectives on the problem. In addition, there will be an association with past experiences. A troubleshooter is also a good associator, learning from past mistakes and repeating good behaviors. Whenever we encounter a new problem (in life or trading) it is interesting raise some points first:
What is the real problem?
When it happened?
What is preventing me to solve it?
Is this problem influencing other areas of my life? (Remember that we are inseparable beings)
Is this above a manual? No, we do not like manuals. They are some points to help you to think better. There is no magic formula for anything. But there are the so-called starting points, which are useful when we have no idea where to start. Then your experience will guide you to your own method.
Now it is the part that seems self-help book: play sports and take care of your health, family and be happy. No problem will resist to a motivated person. And you can not "blame the market" by your misguided actions. Having this empowerment, this sense of responsibility, brings more clarity to understand what the real problem is, which is the first step to find a solution.
If there are still doubts, complement the reading with our post When in doubt...
Although the best investors and traders understand the importance of patience, it is one of the most difficult skills to learn as an investor and trader. So much of trading is psychological, making patience a great virtue for investors. Exhibiting patience when entering a trade and having patience while a trade develops are integral parts to successful trading and investing.
How to develop patience?
It is all about training. There is no magic neither a secret tip. Given this, here is something that might help you with this training.
First of all, turn off your news provider as a guidance for trading. Yes, you should be informed about what is happening in the world, but don't waste time tuning in to the financial media to see if anything happened today that warrants a change in your portfolio. This is only past analysis, because they will try to explain what happened, since nobody can predict the market.
Secondly, you need give the position time to develop. Most of time the markets will not follow your way just because you've went long or short. As the relation between risk and reward, patience is becoming a rare commodity in investment and will be rewarded as such.
Also, even if you trade with a short-term focus, you must have a long-term performance benchmark. A short time frame to evaluate an investment performance is too noisy - your differential will appear in the long run. Therefore, it seems much more appropriate to make a judgment about our investments over a year period rather than by a day or weekly.
Another great thing is to start an investment journal to write down why you did the trade, the risks you took and, yes, any emotions or concerns when you was sending the order. You will see that as you do it every day, you will have more rational decisions when you’re not sure what to do about a certain investment. Learning when not to trade will be the first sign that you have now the wisdom of patience.
Sometimes things in life does not work out and people say "Oh, I knew it... Why I've insisted?". We may speak it when we make a wrong decision at work, when we buy a sandwich and do not like the taste, and especially when the markets are not going in our favor.
The process decision making is a complicated task always associated with fears, insecurities, doubts and the refusal to accept the consequences. No matter how confident or full of self-esteem you are (and the ones that are too much, doubts are even greater), you will always have fear at this time. And you will deny any kind of external help just to feed your pride or you will try to find support in all possible external assistance to compensate for the lack of confidence in yourself (in the opposite situation). Both cases - not admit you have any doubts or leave your questions take away your part in the process - are terrible examples of how to make a good decision.
Also, there is a curious fact: these two characteristics, associated with fear of making a wrong decision will lead you to nowhere. You may lose an opportunity because you have not started soon or because you have started too late.
How to get around with it?
Admit you have questions. Doubt every decision that you are taking and do not rely on external comments. Stay comfortable enough to try to understand all the consequences that can happen if you take an action A or B. But, that's the main point, do not expect to have 100% of certainties to start. You will never be 100% sure, and not all of your certainties will be proven as true. Taking risks and acceptance of the consequences are parts of life. Admit it and move on!
"I was looking at the markets and had an idea for a new investment method. As soon as I took an historical series of data and my favorite computer program I've started doing my "backtest"! A few hours later, I've said: "It is alive!", "It works!". Can not wait for my plans of wealth. Everything comes to my mind as I contemplate the beautiful return curve of my "backtest"!
Full of confidence, I'm ready for the real life! "
The beginning of this text reflects the daily lives of those whom try, somehow, beat the market. And at this time, the trader may come across three possible scenarios:
1 - Your new theory does not work after the "start";
2 - Your theory works for a while and then never again;
3 - Your theory is still running and your account increases every day.
After reading some works of Sir Karl Raimund Popper - one of the greatest philosophers about history of science - and a lot of time thinking, we say that a theory can be considered a theory if it has been tested and rejected or if it is not yet known if that is wrong .
One might already conclude immediately: a theory is never right? Yes, exactly. Let us recall here the Black Swan logic (book from Nicolas Taleb, a great work). A theory will never be certain because we will never know if all swans are white and we can not infer that all of them are because we did an historical analysis and we have never seen a black swan before. You are following the reasoning? So let us return to the three scenarios traders face after their backtest.
1 - Your new theory does not work soon after the start
This had happened because the historical data had no example of what just happened and it had bucked his new theory. The dynamics of the market, the information available and the relationship between supply and demand was changed right after he "put to the test" his new method. And this has a strong correlation with the following scenario...
2 - Your theory works for a while and then never again
Although it is very similar to scenario 1, the big difference is in the fact that the current situation of the market still follows the same backtest behavior, or a little worse, the theory is developed with overfiting - over-adjusted. So many customization were made to make the theory profitable that it is impossible to generalize any changes in the market. The backtest learnt everything that happened in the past that makes it have a blind vision of the future.
3 - Your theory is still running and your account increases every day
Finally, we might conclude that this is the winning scenario. The theory works! Yes, indeed, but only to the point where it will be disproved. And on this day, the system will fail and you may have devastating consequences. Confidence in the system and the confidence of the trader inflate as the account balance does. And a very full balloon burst more easily and more strongly that a balloon not so full. The difference between this scenario to the others is that the unlikely event has not happened yet.
So can we say that we have no escape?
Yes, we have. You can not look only at the historical result, but you should look on the positive expectation of returns. Your system will go wrong someday, for sure, and by "go wrong" I do not mean a few days of losses. I mean a sequence of losses, with no "apparent explanation." Let's say the system has only 0.1% chance of failure. That is, on average, only 1 in 1,000 times it will not work. First some points that must be understood:
That said, what should we pay attention? The maximum loss that we can have when the system goes wrong, plus the flexibility to update it. Let's focus on the first thing. Knowing the maximum loss will help the trader to make the calculation of the expected return. Using again Nassin Taleb, we quote the example given in his book "Fooled by Randomness". The market may have a 70% chance of going up and provide 1% gains. If it does not go (the other 30%), the losses may reach 10%. Considering that the trader has $1,000, the expectation of the trader in this case is negative by $230. Why? For every 10 times he wins $70.00 in total, but will lose $300, with a final balance of $230.
It may sounds interesting having a winning rate of 70%, but if the trader does not take into account what will happen in the remaining 30%, its might be a beautiful backtest, which began with a beautiful theory, but will not be worth anything.