There is an ambush everywhere from the army of accidents; therefore the rider of life runs with loos- ened reins. . . .
—Hafiz
B
ecause we live in a world where often certain things appear to be commonplace and “normal,” we have developed a greater feeling of certainty as it pertains to our daily lives. Human beings find a sense of certainty in the belief that our day-to-day world is natural and is simply the way things are. Some of us have grown so accustomed to this feeling that we have a routine that actually bores us, and some of us go out of our way to do something, anything, to break free of the grip of the ordinary in our lives.Often when the unexpected happens, we feel that the odds are some- how changed, but this is usually seen as temporary. Often the truly ran- dom nature of things is not regularly apparent enough for us to see that whatever happened could have occurred at any time and that we are at risk in that manner at all times every day. For example, because most peo- ple will be in a car wreck perhaps only once in their lives, the everyday risk of driving seems to be very low. If we do have a car wreck, we con- sider it a “random” event that only seemed manifested to us “by accident.”
We feel this way because normally we drive every day without incident.
We have come to feel that it is more of a certainty that each day will pass without the random event occurring to us personally. If it does occur, we think it is a fluke.
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The fact is, most people create the “accident” that they find them- selves in by failing to make the connection between their actions and what happens next. For example, most people who drink and drive don’t believe the problem was entirely theirs, yet it was their impaired judgment that increased the odds that the seemingly random event would happen to them. Because they drive sober and without incident 95% of the time, they fail to recognize that during the 5% of the time they are not sober, the previous 95% success rate is now null and void. The rules of the game have changed. They are in an entirely different environment that bears no resemblance at all to the previous degree of certainty.
Our mistake is not so much in our perception of reality, but in un- derstanding the nature of how probabilities affect us all day, every day.
There are very few things in life that involve certainty, and the fact that some things only happen to each of us individually maybe once in our lives does not change the probability that they will happen every day to someone.
Indeed, the entire business of actuary analysis is an attempt to ana- lyze how best to spread the risk of an event that willhappen across as many people as possible to whom it mighthappen. Insurance companies make money by diluting the risk in this way, and they do best by writing policies to people to whom the event will almost certainly never happen.
As an example, the reason active scuba divers pay much more in life in- surance premiums is that a certain percentage of scuba divers will drown each year. If you don’t scuba-dive, your risk of accidental drowning is lower; therefore your premiums are lower. But the fact is, someone will drown this year, and the odds that are a regular percentage of those peo- ple will be scuba divers. Ask scuba divers what they think of that risk and all of them will most assuredly say, “Not me . . . I don’t do anything stupid when I dive.” Those divers have a sense of certainty that “drowning won’t happen to me.”
This issue of perception regarding certainties and probabilities changes completely when we begin trading. We leave the comfort of a world that usually works a certain way and enter into a world where the truly random and unexpected can happen at any time. The events are ran- dom and unexpected not because the market is indefinable or because price action is somehow so mysterious as to defy explanation, but be- cause we as individual traders cannot possibly know everything about the market at all times; therefore we have a percentage of risk that is certain.
Reducing this risk is not about more study or more knowledge. Reducing this risk is about knowing probabilities.
All attempts to profit from a trade are in reality a best guess regarding future price action. It really doesn’t matter what your methodology is or
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which technical or fundamental approach you ultimately settle on as the right combination of risk/reward system right for you. Because the nature of trading markets involves risk and uncertainty, it is impossible to know exactly how any one trade will eventually play out through price action until it gets there. Markets are not definable past a certain point, and no matter the depth or scope of pretrade analysis or research, there is always the possibility that prices won’t respond in the anticipated direction or won’t respond in a time frame you are willing to trade in. Wall Street and LaSalle Street are full of traders who were right too soon, waited too long, got out too soon, got in too late, and so on. All of those kinds of results—
whether this means small profits, no profits, small losses or big losses—
are simply because whatever systematized approach was being relied upon had reached its unique limit or the trader failed to appreciate that limit. They were all “best guesses,” and that means they don’t work 100%
of the time to begin with.
Reducing your options to the best probability before you enter a trade is a function of several things. First, if you have done a proper assessment of general conditions according to your trade plan, there will be a point where prices are more favorable for an entry and will respond by an ad- vance in the direction of conditions. Waiting for that point and then exe- cuting immediately is your best option, but where is that point?
When entering a trade we don’t have the benefit of knowing if our execution point was the best price area; we find out sometime later. To improve your odds of timing your entry better, develop a series of “if–then”
scenarios and ask yourself which is more likely.
Let’s take an example from a potential bullish market condition. We could start with the hypothesis, “If conditions are bullish, and the trading population responds accordingly, then prices should rise.” I know that sounds overly simplistic, but let’s look at the various psychological as- pects of such a simple statement and how that could play out in day-to- day price action.
If prices are at the moment still declining, this means either most traders don’t feel conditions are bullish just yet, shorts are still in control of the market, or some combination of short-term and long-term market players looking for an opportunity is such that so far the net order flow re- mains offers. Since in most cases the majority of traders will not see a change in conditions far enough in advance to buy into a declining mar- ket, nor will they hold a position for the time required to earn the largest gain from a change in trend, we can assume that the majority of traders are either still short the falling market, on the sidelines waiting to make a move on the short side, or executing regularly from both sides with vari- ous results to their accounts. But as far as you are concerned, buying into
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a declining market has a degree of risk; hence the old favorite rule, “Don’t pick tops or bottoms.”
The absolute best place at the lowest risk for a trade is at the top or bottom, but finding that point is where the issue of probabilities comes in.
If you knew the market had bottomed, and you were willing to assume the risk that conditions were turning bullish, you would want to execute at your price right now. It is absolutely certain that sooner or later that mar- ket will bottom, but is the current bottom a bottom or thebottom? No matter your research or analysis, you cannot know that for certain until sometime later, so you must think in terms of probabilities. Let’s look at an example, shown in Figure 3.1.
In this figure, prices are moving in a general sideways trend. This means that buying and selling pressure is about equally balanced, because a market cannot steadily advance or decline unless there are more orders net from one side or the other. At this point in time, both the profitable shorts and the potential longs are seeing two opposing things. For the profitable short, his risk is increasing because no further net price action
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FIGURE 3.1 Nearest Futures Contract, CBOT Corn for July Delivery, as of De- cember 2005
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is favorable for additional profit; he must either cover or wait for the trend to resume. For the potential long, the lower the price goes the better the opportunity if the change in trend is coming eventually. The longer the market does not go down, the better the potential that the actual bottom is finally in place.
In both cases, a choice to enter a buy order is the only result, no matter when either side decides to do it. How those buy orders are now being absorbed by early long liquidating with a sell order is a great clue.
If the buy orders are mostlylate (old) shorts liquidating, a drop in open interest will result. The traders with the selling point of view are chang- ing their minds. Figure 3.2 shows this well. Note the steady advance in corn prices after high volume and a drop in open interest from that point forward.
The study of volume and open interest (V/OI) is an entirely separate issue from the psychology of thinking in terms of probabilities. If you were looking at a potential bullish scenario developing and you knew that most traders were bearish or prices were still declining, at some point you
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FIGURE 3.2 Nearest Futures Contract, CBOT Corn for July Delivery, as of April 2006
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knew that would change sooner or later because it is not reasonable to expect corn prices to drop to zero; somewhere between zero and where they are now, there willbe a bottom price. It is more likely that a bottom is forming when no one wants to sell the market anymore; it is too risky for an additional price decline as far as the shorts are concerned. The po- tential bulls see their risk dropping the farther the market goes lower, and at some point they will simply say “Wow! That market is on sale!” and buy. If that scenario develops to the point where the buy orders (both new longs getting in and the old shorts getting out) compete with the sell orders (late shorts getting in and early longs getting out), and a drop in open interest results, the probabilities are rising that a bottom is forming because the only trade group who is most at risk for a price rise would be the open-trade winning shorts. The late short is dead meat anyway so he doesn’t count.
When these two opposing points of view actually do something, you have the potential of a bottom forming at that price area. The V/OI ratio is only one clue. As a trader thinking in terms of probabilities, your only question is what is more likely to develop as time goes on. Sooner or later the market would have bottomed anyway. If you want to be on the right side for the pull when the trend changes, you have to ask yourself when and where it is most likely to happen, and that is not at any one price; it is a factor of the psychology behind the price.
The same psychology is behind every form of trade selection you do.
You are looking for what is most likely, given your understanding of the bullish and bearish pressures that are playing out, as you understand them. If your time frame is shorter or longer, there will still be a more likely scenario that needs to be considered when you make your trade analysis. It needs to be considered as part of your trade plan because a flexible trade plan accounts for the possibility that something is changing.
Your goal as a trader is to go with the path of least resistance, and that is a factor of probabilities, not analysis.
I have found that the best thing to do when I am looking for the true potential of a trade is to argue the case from both sides. I ask open-ended questions: Who is winning? Who is losing? What could make either side quit? What will cause the bulls or bears to liquidate? What will cause them to commit themselves more fully? Then the big question: Which is more likely?
By asking several kinds of questions designed not to form a certain absolute conclusion but to uncover the market’s bestprobability forward, you as a trader have more options open to your trade selection process.
As that trade selection process gets better and better defined over time, you will see that some trades are better for you personally than others. By
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thinking in probabilities you reduce the potential to have a loss by not tak- ing low-probability trades, and you increase the potential to let profits run when you are in a high-probability trade. You can’t know for certain ahead of time, but you can see the likelihood of one situation developing better than another.
At that point, you take your position and wait.
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23 R U L E # 4