Questioning Convention
Where Is The Weakest Link?
by Damir Smitlener
With the year coming to a close, it's a good time to revisit your trading system. Here are a few things to consider that you may never have thought of.
Varied and various forms of technical analysis have been used to determine which way the market will go. Much of this effort has been devoted to creating indicators that are used to find turning points and identify trends. Despite that effort, most traders fail to extract a living from the markets. It is widely assumed that these failures aren't due to specific techniques, but rather to the limitations of the traders who are attempting to follow the techniques.
But what happens if you stand this idea on its head? What if you assume traders are in fact not the weak link in the chain, and the problem lies instead in the most common clichés embodied by technical analysis? What if you stop trying to ride trends and eliminate stop-losses?
A PROFITABLE TRADING SYSTEM
Perhaps the best-known trend-following system is the Turtle approach that trader Richard Dennis made famous in the 1980s. Simply, this approach waits for a 20-day breakout, either up or down, then takes a position in the same direction. One explicit assumption of this technique is that most breakouts will not lead to profits. Consequently, a built-in loss-prevention algorithm keeps you in the game long enough to catch the big moves. But if so many breakouts are in fact false, then it should theoretically be possible to find a system that profits from that.
What about stop-losses? A traditional stop-loss is a price-based, predetermined exit that is placed in order to mitigate damage from an adverse market move. This definition may seem to imply that losses are a function of being “wrong.” That is not, however, completely accurate: losses are also a function of position size. While seemingly obvious, this detail is often overlooked.
Another overlooked characteristic of the price-based stop-loss is that it forces the trader to be right not only about where the market is going, but how it gets there. It does the stop-loss user no good if the market goes up 800 points if his stop-loss, 1.5 points below entry, was triggered three minutes before. Because of such situations, using stop-losses can greatly increase the difficulty of playing the market game.
FIGURE 1: DJIA data from 1930 showing distribution of streak length in days and percent odds of longer streaks.
...Continued in the December issue of Technical Analysis
of STOCKS & COMMODITIES
Excerpted from an article originally published in the December 2004 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2004, Technical Analysis, Inc.
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