Editors' pick: Originally published May 25.
In the first part of my series about "real" trading, I discussed how nobody is able to look into the future. Naturally, that applies to me, too. So, don't allow yourself to be distracted from the essentials. Learn to work with the facts. This raises the question of what the essentials and the facts are. That's what we'll begin exploring today.
Once I had a conversation with a mathematician about the financial markets. We were strolling around a large stock market trade show, and at every second exhibitor there was an expert on a stage presenting his view of things, with powerful eloquence, to an audience that was hanging on his every word. These experts often referred to charts that were projected onto large screens. This trade show was a new experience for the mathematician, as he had learned his trading at a hedge fund and had never been to a commercial trading event before.
He shook his his head in exasperation. This is the gist of what he told me: "I can't look at those damned charts any more." Initially, I just simply noted this and didn't ask him to elaborate.
In the evening, when we were sitting in the hotel bar drinking good German beer and going over the day's events, he said a sentence that has remained indelibly etched in my memory: "Trading is a statistical problem." He added, "I don't know why everyone is constantly looking at charts." Boom! That made an impact. Of course, he was right. After all, what am I really supposed to be able to deduce from a chart? His statement would change my trading.
Together, let's consider what a chart is. It's a graphical representation of the price performance of a financial instrument. Of course, this definition can be applied to all financial instruments and every period. If you look more closely, however, then you realize that a chart is nothing other than data points that have been joined together with a line. (We'll exclude bar charts in any form here.) So, you just go ahead and connect the individual data points (usually closing prices) with a line and that becomes a chart. To put it more precisely, a chart is therefore a data series that has been compiled graphically. This information is compiled graphically because it's then easier to interpret it visually.
Data series are information. Information can be analyzed, according to distinctive features, and according to patterns and interests. Yet, in the course of this, why should I go and analyze just one single chart (or data series) if, with the help of a computer, I'm able to analyze thousands and thousands of pieces of data at the press of a button?
If you think about it carefully, you have to admit that there's no sensible answer to this. Nevertheless, these days all brokers provide powerful charting tools. With these you're able to add lines, or display indicators and do many other things. Yet, that then looks rather more like playing with an Xbox or a PlayStation and has nothing to do with "real" trading. The reason is that, in this case, the saying "a picture is worth a 1,000 words" is not appropriate, because a chart tells us absolutely nothing. Well, at least nothing that can help us as traders.
Trading is a statistical problem. Remember that for the rest of your life. That is why we have to take a different approach. A chart is always an individual case. It may well be the case that stock XYZ has turned for the third time at the ABC support level. You can also spot that on the chart with the naked eye. But is it possible to derive a generally applicable rule from this? Certainly not. Is it generally a good idea to go long in the case of a 10-day low, for example, simply because a support level for a given stock has held two or three times in the last few months? You'll never find the answer to this question with the aid of a chart. It doesn't matter how long you stare at the chart or how many lines you draw on it.
And with that we can make a conclusion partly based on my previous article. Nobody is able to look into the future. Nobody knows what will happen. Nevertheless, you can trade stocks successfully if you skillfully analyze the available data. This brings us to the topic of statistics, which we'll discuss in greater detail soon. And please stay the course, even if the word
"statistics" triggers a kind of flight response in you. This topic is much simpler than you think. Which once again brings us back to the essentials, and so we've come full circle.
Finally, another disclosure of a different kind: The mathematician whom I mentioned at the beginning is now a good friend of mine. And he and I helped to set up moomoc. Our specialist field is quantitative finance. But by now that shouldn't surprise you.
This article is commentary by an independent contributor.