On predicting market direction

On predicting market direction

Where will the market go tomorrow ? This is the most common question every trader faces. No matter how small or big the trader is, how much experience a trader has, whether the trader is system based or discretionary, everyone wishes to predict the market direction. This post is my attempt to dive deep into this market prediction business.

Market direction is 50-50

Let me start by asking this basic question to all the technical analysts, system traders or discretionary traders. Is there anyone who is right on market direction for more than 50% of time over a long period of time ? Please note that I am not talking about the win rate, because an option selling strategy may have a win rate much higher than 50% of times, even if the view on market direction turns wrong. 

Whatever little experience I have and whatever handful of experienced traders I have interacted with, whatever strategies I have backtested, all of them work on a lesser than 50% successful prediction of the market direction. Someone may be right much more than half the time, but that could be a lucky winning streak in the short term. Someone may be right a much lesser number of times, and that could also be an unlucky losing streak in the short term. In a large number of trades, the view on market direction should converge to 50% or even lesser.

Every strategy works

If you are convinced that market direction can be predicted more than 50% of times over a large period of time, please let me know the indicator or strategy you are using and I will be happy to backtest it and get myself proved wrong. 

If you have a hunch that market direction cannot be predicted more than half the time, you may find the following thought intriguing:

“You do not need a complex strategy or trading indicator to be profitable in trading. Almost anything should work. Since the market can go only up or down, any random decision has 50% chance of being right or wrong.”

Just pick any strategy which is simple to follow. It could be simple moving average, simple price action based on previous day high or low, recommendation from someone you trust, taking position using random coin toss, or whatever simple comes to your mind. You do not need to spend a lot of time in coming up with that perfect strategy because the secret ingredient is not in the entry criteria. 

The Secret Ingredient

So what is the secret ingredient ? You might have heard it too many times from so many experienced traders that strategy (entry criteria) is the least important thing in trading. Instead, trading is all about following things :

  • Risk management : Now you know for sure that your market view will be wrong at least half the time. So you need to make sure that the losses on these trades are small enough so that they can be compensated by profit on the other half of the trades.
  • Letting profits run : Now you know that you will be correct max 50% of the time in the long run. If you start exiting the position with small profits, you would not be able to cover your losses in half of the losing trades which are yet to come. So you need to sit on a profitable trade, even pyramid it by adding more quantity, so that you have enough profit for the losing times to come.
  • Position sizing : Your position should not be large enough that few losses wipe you out of the game. You need to survive to be able to pick the big profitable trades in the long run.
  • Psychology : If you leave the trading game because of losses, you have actually booked your losses forever. Until you are in the game, you have a chance of recovering them and making a profit as well. You need to do everything which keeps you in the game. Emotions are real and different for each individual, so you need to make your trading style as per your personality. 
  • Diversification : Play as many assets as possible. Do stocks, index, commodities, currencies. Do option selling, option buying, futures, cash market. This way, you are reducing your chances of getting unlucky. You only need a few big profits as you have kept your losses small through proper risk management. Diversification will help you by providing more opportunities to be in the right place at the right time. 

Special call out for a mystery ingredient called Experience. This is something which can not be taught. It will come with years of consistent practise. Traders with experience have a hunch about how a particular stock behaves which you can call discretion and may not be put into logical rules. Experience is an edge in itself. To gain this edge, we need to survive the market for many years. 

Each of these ingredients deserve a post in itself. More in upcoming posts of this series.

So, forget worrying about where the market will go. Forget worrying if your strategy is good enough or not. Forget worrying about being right all the time. Just bet on one direction and stick to the best practises. Keep taking many small losses, and keep putting yourself in situations where you can win super large.

This is the second post of the series “Reminiscence of a retail trader”. Read the introduction post by clicking here.

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