Investors, especially short-term traders, are usually better off waiting for the movement in price to confirm a trend or reversal rather than try to predict what is going to happen next. Section two of this article looks at some ways we can rework our thinking to gain a better edge. The first section looks at the reasons why predicting can be a problem.
The Prediction 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 movement 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. During these times, predicting can be especially dangerous if expectations turn out incorrect. For example, predicting that 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. Analysis of individual securities is often 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 in 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 that a particular stock 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 rarely works 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 for 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 that the stock will fly in the anticipated direction in a straight movement, leading to large profits. 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.
Alternatives to Prediction
Given that we now understand trying to predict a turning point in the market can be very costly, one asks, "If I can't predict, how do I make money?"
Whether attempting to predict the market or not, generating consistent profits from short-term trading is exceedingly difficult, even for the most experienced investor.
The answer is that we follow the price, and we can do so by following the guidelines below. This is not an exhaustive list of market dynamics, but understanding these should help traders find themselves more on the right side of the trade than on the wrong side.
- Prices fluctuate in waves. Looking at any chart after understanding the points above, all traders must understand that prices move in waves on all time frames. This means that, even though prices may fall, traders don't need to panic and jump out of positions as long as the longer trend is still up. However, they still should have an exit point in case prices are no longer in an upward trend in their time frame. Short-term traders can participate in each of these waves but must remain nimble and not be tied to one direction when doing so. To predict that prices will move in only one direction is to disregard the factual tenet that prices move in waves.
- Don't assume support or resistance will hold. A very common misconception is that support or resistance will hold, or that a break of these levels will cause a substantial breakout. The position traders have often determines what they predict will occur. What traders need to realize is that support and resistance levels are simply important price areas. Making assumptions that a breakout will occur or that a level will hold off a further move is an attempt to predict the market. Rather, traders should watch what occurs around these levels and then enter as momentum moves in one direction or the other. If resistance holds and prices retreat, then a short position could be entered, for example. If a breakout occurs, then trade in in the direction of the breakout. Keep in mind, false breakouts occur, and (to repeat) prices move in waves. Don't be tied to a position simply because a position showed a profit for a time.
It is better to think of support and resistance as pivot points for price and areas to look for entries and exits. By doing so, we are not predicting that something will occur or going against the prevailing price movement. Instead, we enter into the current price flow. This makes trading "matter of fact" as opposed to emotional. We have picked out important levels that will help us isolate the price waves a market is moving in. Then we can take a corresponding position as prices react at these levels.
Predicting the markets can be dangerous and, ultimately, predictions are not needed in order to make money trading. By realizing that prices move in waves and that we should not predict whether important levels will hold or be broken, we can enter trades at significant points but in reaction to what price is actually doing and not what we expect it to do. Traders benefit by remaining nimble in their positions and not being tied to a particular direction because of a prediction.
Cory Mitchell CMT can be contacted by Twitter @corymitc