Module 12 Innerworth — Mind over markets

Chapter 181

Cautious Optimism

Dan’s been tracking IBM for five months. He knows the price pattern by heart, its ups and downs, and the conditions that precede and follow each new trend. Now it’s just a matter of psychology. He must execute each trade in a calm, relaxed, and focused manner. He must stay optimistic, but he must also be cautious, and anticipate adverse events that may go against his trades.

It’s hard to develop a winning trading strategy. Even when historical data has supported the performance rate of a strategy, there is still a possibility that the strategy will fail in the future. So when you’re fortunate enough to discover a winning strategy, you need to implement it while in a peak performance state. That means discipline and control, and following your plan with unflinching accuracy. Once you have a proven trading strategy, it’s useful to be optimistic, not overly optimistic, however. One should be cautiously optimistic. Your strategy may work most of the time, but no strategy is likely to work all of the time.

For merely illustrative purposes, pretend that an unlikely trading strategy is actually a reasonable approach: After looking at the price patterns of IBM for five months, Dan discovers that 95% of the time, the stock price increases $1 on Tuesdays and Thursdays at 11:52 AM. Working under these assumptions, one can use probability theory to estimate the odds of success. If the strategy were used an infinite number of times, under identical market conditions, we would expect the strategy to work 95% of the time.

Note that testing this proposition means that one is optimistic about its performance. Although it’s impossible to use the strategy an infinite number of times, one can use it 20 times and expect it to work about 9 times out of 10. If the approach is abandoned prematurely, however, it may not work with that frequency; thus, one needs to be optimistic enough to stick with it a fair number of times to see if it works.

That said, one must also be cautious. A central assumption of probability theory is that the trading strategy must be applied under identical market conditions, and we know that is a hard condition to meet. Therefore, even when a strategy has a past track record of 95%, we should expect it to work less than 95% of the time in the future because market conditions change frequently. (Also Note: Even if market conditions were identical at each execution of the strategy since 20 times is much less than infinity, it’s quite possible that the strategy will not work even at a rate of 1 out of 20 times.)

And that’s why risk management is crucial. It’s vital that you calculate the risk to reward ratio and make sure you are risking a relatively small percentage of your trading capital. Also, set a stop loss point to protect yourself further. In the event that you encounter one of the few instances where there are unexpected anomalies in the markets, in which your strategy will fail, you will be protected from significant loss.

In the end, implementing a strategy requires cautious optimism: you’ve got to be optimistic enough to believe in your strategy to implement it in a calm and relaxed manner, but on the other hand, be realistic. Unexpected market conditions may temporarily work against your strategy, so you must also show extreme caution by limiting your risk, and protecting your trading capital.

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