Efficient market theory is simply wrong. While no one can predict what will happen in the market tomorrow you can still make piles of money if you play by the numbers.
For decades analysts and money managers have been trying to “value” a stock, or company, and predict it’s future value, based on various measures such alpha, beta, PE ratios, etc., but the one fundamental problem with these measures of prediction is that they are based on the subjective opinions an analyst. This is precisely why different investment firms often make very different predictions of the future value of a stock. If it wasn’t subjective there wouldn’t be so many different predictions and, consequently, there wouldn’t be a need for thousands analysts in the world. I’m not suggesting these measures have no value, because they do, but they are subjective and so they must be taken this way when considering your trading strategy.
Just as different analysts have different predictions for the future value of a stock, each person across the world who is actually involved in the stock, those who “actually” make the market for that stock, also have their own opinions of future value. Since the value of a stock is, as a matter of fact, based on the actual combined opinions of those involved in trading it, the only way to actually predict what will happen tomorrow is to know what every one of these people is predicting. Unless you happen to be omniscient this isn’t likely going to happen for you. So why would you want to base your trading decisions solely on the opinions of 1, 2 or 10 analysts? Or even your own opinion for that matter? It just doesn’t make a lot of sense.
Successful trading of stocks, commodities or currencies is a numbers game. We can in fact make non-subjective predictions based on probabilities that will improve our performance and let us cash in big on the markets.
So how does it work? Let me use an analogy to explain. My insurance company has no idea if I’m going to drop dead tomorrow from a heart attack. But by analyzing the statistics of other people with my life style they can come up with a probability based on actual data and sound mathematics that will tell them the odds that I will drop dead tomorrow. This is how they determine my premiums such that they make money in the long run. Trust me; it’s not based on a handful of analyst’s subjective opinion of my life style. It’s based on hard data (statistics) and the mathematics of probability. Insurance companies have this down to a science. Unlike the old days with slide rules and massive books of mortality statistics, they use computers to crunch through the data and determine the probabilities of certain event. As an investor you may want to take a look at the financial success of insurance companies over the years and you’ll see just how powerful this approach is.
In much the same way, making a trading decision based on probabilities makes a lot of sense to me. If you’re a poker player it should makes make sense to you as well. Sure poker is largely about B.S., but there isn’t a professional poker player out there who doesn’t know the odds of his hand winning and who doesn’t measure this against the likely size of the pot they may win (risk/reward). Successful poker players don’t know how the hand will turn out when they place a bet, but they’re playing a numbers game and over the long run this will allow them to beat those who are not playing by the numbers.
Trading the markets is not much different. It’s a numbers game as well and technical analysts understand this. They know that a certain chart pattern, or set of signals will not always be correct, but they also understand there’s a certain probability of it being correct based on past similar occurrences. Also based on past similar situations they can determine the range of possible reward outcomes, again probabilities based on real data. With theses probabilities in hand they can calculate a probability risk/reward ratio which tells them if they should enter the market or not, and with how much money. This is very similar to what my insurance company does when deciding if they want to insure me, and what my premiums must be for their risk/reward ratio to be in their favor.
In the early years of the market fundamental analysis (alpha, beta, PE ratios etc.) was king and trading was considered much like gambling. In the past few decades the tides have begun to turn and technical analysis has become a major tool for active traders and is used heavily by the large trading and hedge fund companies. And trust me they wouldn’t be doing it if it didn’t work.
One of the major reasons for the rise of technical analysis as the primary tool for traders is the easy access to computing resources. It used to be that performing technical analysis was a manual process of studying charts, drawing trend lines and looking for patterns. Then the technical analyst would crunch the numbers and make a decision about the stock in question. Sure this approach, being based on probabilities derived from historical data, is much less subjective than typical fundamental analysis techniques, but it was a very time consuming process meaning only a limited number of stocks could be analyzed in a reasonable period of time.
Today automated trading systems are taking over in a big way. The resources required to automate your trading ideas in to a automated system are accessible to everyone, not just the big dogs. And with the ability to automate your ideas comes the ability to test your ideas quickly against years of historical data before you throw your money on the table.
Playing by the numbers just makes sense. If you want to learn more about developing a trading system that fits you as well as how to automate and historically test it then signing up for the mrautomate.com newsletter is a great place to start. Simply grab your copy of our free Trader’s Guide to Money Management and you’ll be signed up and ready to go.
