Blending Market Realities with Forecasts
Many trading systems and just about all opinions of market direction attempt to forecast the market. Whether you use fundamental or technical analysis, if an opinion is being generated, you are attempting to forecast the market. Some use Elliott Wave theory, some rely on P / E ratios, but the overall purpose is to estimate where prices will be at some point in the future.
As traders and human beings, we will always have opinions and ideas based on our beliefs about what we have experienced. No matter how hard we try not to have them, we just can't seem to help it. How we use these opinions, forecasts and beliefs is important.
Where the markets are concerned, the first thing we need to realize is that all opinions or forecasts about the markets are nothing more than fantasies. At the moment a forecast is formed, its "Reality" of coming true does not exist.
Having said this, I must ask: Do we want to just trade fantasies? Obviously not! Then, how can we use forecasts to help us in trading, rather than hurt us? This is an important question.
Let me help answer the question by giving some examples and analogies of how forecasts can help or hurt us.
Example One: Let's say you believe the forecast generated by an Elliott Wave theory indicates that stock XYZ is about to begin a trend up. Even the MACD is indicating positive divergence. You say to yourself, "A no-brainier! I'll buy here and wait."
Another week goes by and instead of beginning its up trend, XYZ stock goes lower. You say to yourself, "I entered this trade too early, but I BELIEVE it will head up very soon", so you hold on another week.
The next week, the stock goes lower, and, now, you are worried. The MACD bullish divergence is still present, and the Elliott Wave forecast remains the same, but it looks as though it is heading down for one last time, a shake-out. You think to yourself, "Can't go much lower."
The next day, the stock plummets; you panic and sell out your position and scratch your head asking, "How could that happen?" The answer? It happens all the time to traders relying on the forecast and not the actual market!
In this example, the trader held on to his fantasy based on his forecast. His faith in the forecast led him to avoid using a stop loss. This is typical for traders locked in to this type of forecast trading. After all, their ego is involved here, too.
Let's take the same example and show how to use the forecast to our advantage. Instead of just buying the stock outright, based on its positive forecast, we wait until the stock shows signs of actually reversing its trend down. We feel that, based on our forecast, this stock will turn around soon, but the current reality indicates that it is not happening now.
By not purchasing the stock and waiting for the price of the stock to show signs of actual strength, we are trading the realities of the market and not the forecast. However, we are using the forecast to get ready and to keep this stock in our lists of possibilities.
Look at forecasts as one more tool to help round out your trading. Use the following analogy as a way to think about them. Let's say you are planning a sailing trip for the day. You check the weather forecast, and it is not good with heavy rain and wind expected. But, you have a great boat, and you're an experienced sailor, so off you go.
As you leave the dock, the weather is perfect. It is sunny with light winds. Now, I ask you, even though the forecast is for very heavy rain and heavy winds, would you wear your rain gear now or wait until conditions change? I think most of us would wait until conditions actually changed.
You would also set the sails of the boat to match the current weather conditions and winds and not the forecasted conditions, which may or may not actually happen. If you were to put up small storm sails as you left the harbor, you would not be able to sail the boat in the light air conditions. But, as weather conditions changed, you would change your settings to match the changing conditions!
In this analogy, a sailor would use the forecast to be PREPARED for a possibility of bad weather by bringing rain gear and the proper sails and crew. It is the same with trading! Whatever the forecast is, take note but trade with the current conditions and be ready if conditions change. In other words, trade the realities of the market, not the forecast! Or, put another way "Live in the present and not in the future or the past!"
Bennett McDowell’s Multi-Monitor Set-Up for Trading Using eSignal and Applied Reality Trading
When trading the "Realities" of the market, you must also trade within the "Realities" of your risk capital. Implementing sound money management encompasses many techniques and skills intertwined with your judgment. All three of these ingredients must be in place before you can be said to be using a money management program along with your trading. Failure to implement a good money management program will leave you subject to the deadly "risk-of-ruin" exposure, leading eventually to a probable equity bust.
Whenever I hear of a trader making a huge killing in the market on a relatively small or average trading account in a short period of time, I know the trader was most likely not implementing sound money management. In cases such as this, the trader more than likely exposed him or herself to obscene risk because of an abnormally high "Trade Size." In this case, the trader (or, more properly, "gambler") may have gotten lucky, leading to a profit windfall. If this trader continues trading in this manner, probabilities indicate that it is just a matter of time before huge losses dwarf the wins, and / or eventually lead to a probable equity bust or total loss.
Whenever I hear of a trader trading the same number of shares or contracts on every trade, I know that this trader is not calculating his or her maximum "Trade Size." If this person were trading the maximum, the "Trade Size" would change from time to time.
To implement a money management program that will help reduce your risk exposure, you must first believe that you need to implement this sort of program. Usually, this belief comes from having suffered through a few large losses that caused enough psychological pain for you to want to change. You need to understand how improper "Trade Size" will actually hurt your trading.
Novice traders tend to think of trade outcome only in terms of winning and, therefore, do not think about risk. Professional traders focus on the risk and take the trade based on a favorable outcome. Thus, the psychology behind "Trade Size" begins when you acknowledge that each trade’s outcome is unknown when you enter the trade. Believing this makes you ask yourself, "How much can I afford to lose on this trade and not fall prey to the 'risk-of-ruin' outcome"?
When traders ask themselves this, they, then, adjust their "Trade Size" or tighten their stop loss before entering the trade. In most situations, the best method for adjusting your "Trade Size" and setting your stop loss is to base each on market dynamics just as we teach with the method "Applied Reality Trading™". This method is available as a system that you can add onto your eSignal application.
During "draw-down" periods, risk control becomes very important, and, because good traders test their trading systems, they have a good idea of the probabilities of how many consecutive losses in a row can occur. Taking this information into account allows the trader to further determine the appropriate risk percentage to take on each trade.
Most trading systems use a moving average to base trading decisions on, especially trade exits. Moving averages are usually derivatives of price and, therefore, do not represent the natural "Truth" of the market. Furthermore, man-made, derived moving averages can be adjusted with variables, such as simple versus compounded, and are subject to alterations based on opinions and are, thus, prone to subjectivity.
So, I do not recommend using moving averages as primary entry and exit signals because they do not represent the realities of the market. Instead, use an objective trading approach to tell you when to exit the market!
The chart illustrates how we use a "Reality-Based" trading system to trade the reality of the market. When analyzing the chart, notice how the triangular shapes on the chart (called "Pyramid Trading Points™") capture the reality of the market as it is unfolding. Both trade entries and exits are set based on price activity and not arbitrarily set by the trader. This is important because we want to enter and exit the market based on market reasons or "Market Truths".
So, although it is fine to have an opinion as to market direction, it is best to base your trade entry and exit decisions on "Market Truths". Trade the realities of the market as the market unfolds and see if dealing with reality delivers a better result!
Read more about Bennett McDowell's Formula Studies Add-On, Applied Reality Trading (ART) software for eSignal.