Imperfect Market Theory
Random Markets, The Rule of the Screw, General Market Chaos and What to do About it
By Trader Bob
Short Term Stock Trading, the Ultimate Source for Low Risk High Return Investing
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My ideas regarding imperfect market theory and the stock market are essentially as follows: Markets must move in such a manner so as to Frustrate, undermine and defeat the best interests of the majority of market players (Translate: "The Rule of the Screw").
According
to this rule the majority cannot make money in the marketplace. The markets will
totally ignore technical indicators and fundamentals if the majority of the
market players act on those technical indicators and fundamentals.
Price movement is predominantly random, that is not 100 per cent random, but predominantly
random. That is what makes them imperfect markets. The "secret" to making money in the market is locating that small
portion of market behavior which is not random and exploiting it. I do not feel
that conventional technical analysis is of any value in doing this. The problem
with technical analysis is that it will present the illusion of uncovering
hidden relationships between price behavior and various indicators.
I would submit that all such indicators are as random as the price behavior they
attempt to predict and that all profits and losses realized from trading such
indicators will be randomly distributed.
Isaac Newton and the Market Place:
In place of
technical analysis I prefer something I call market momentum theory.
Market momentum is what drives an imperfect market. For more details see my article, Stock
Trading for Dummies.
First law of
price movement is:
If prices move up there is greater probability they will move higher rather than
lower.
Second law of
price movement is:
If prices move down there is greater probability that they will move lower
rather than higher.
And from these simple rules comes the most important rule of trading:
If price goes up
you must buy the market long and if price goes down you must sell.
You may read this and think "well so what?, that is obvious". But trust me most traders and trader wannabes do not think that way at all. When the market goes down they want to buy to get a better price. And when the market goes up they hesitate because price is too high.
And they do not make money! They are a part of the losing majority.
Let us look at the following chart:
This is exactly what system venders show in ads. They show that their system buys the lows and sells the highs. But that is a fantasy and it cannot be done. Random market theory is not going to let you do this. Yet some smart traders see this and they buy the system because it shows traders what they want to believe. Even smart people get sucked into believing that the markets are not predominantly random.
The problem is that when we look at any chart we want to buy low and sell high.
You cannot, however, buy bottoms and sell tops. You can only follow a trend
which has already been established through price movement in the same direction
as the position you are taking.
You must understand that when you elect to buy long a market when price rises
you are in effect buying the market at the worst possible price at the time of
your entry. It's not going to feel good and it's not going to look good on the
charts. But by "buying high" you are probably going to be placing yourself on
the minority side of the market and therefore assuring yourself of profits.
Exiting a Position
Getting out of a position is just as critical as getting in. In my opinion most of the popular ideas for getting out do not work. Let us look at just two of those ideas, the stop and reverse method and the trailing stop method.
Stop and Reverse method:
The stop and reverse method involves utilizing some kind of indicator or a price
based on an indicator. If the system is long one contract and the market comes
back and the price is hit the system sells 2 contracts and reverses to a short
position and so on. Of all possible trading strategies I have found this to be
the least profitable and grossly inefficient with respect to the use of margin.
I will discuss margin efficiency in greater detail later but for now it need
only be said that systems that are in the market all the time tie up your margin
needlessly. Markets tend to move sideways about 85% of the time and consequently
these systems will have your margin tied up doing absolutely nothing for at
least 85% of the time. These systems can also whipsaw you to death while moving
sideways.
A system like
Jordi's Intra-Day2 is, by contrast, very margin efficient. It gets into a
market only when a given market starts significant movement and it is usually
out of the trade the following day. "Jordi" does not tie up your margin.
(see Hit and Run Trading)
Trailing Stop:
The second most common way mechanical systems take profits is through the use of
a "trailing stop." The idea behind a trailing stop is that it allows you to "let
your profits run" while at the same time "locking in" any profits you may have
already made. My experience with system design and trailing stops has been that
the trailing stop is at best a mediocre method of exiting a profitable position.
The problem is that if the trailing stop is too tight it results in your having
your stop tagged right before the start of a big move. Conversely if your stop
is too deep it results in many small profits going to large losses. The other
problem I have with trailing stops is more theoretical. With a trailing stop you
are trying to take profits only after the market has turned against you.
Frequently you are forced to sell out your long position when many others are
trying to sell too. You are then moving with the crowd and this is almost
inevitably going to cause you excessive losses.
Therefore the rule I have developed with regard to taking profits is:
You should try to take profits only when the market is moving strongly in
your favor.
This is much more consistent with my contrary philosophy of trading. If you are
long a market and the market takes off like a space ship you should sell. By
doing so you put yourself on the minority side of the market selling to the
majority of panicked buyers. That is how you make money in this game.
What should you do, however, if your position starts out bad, get worse and then
threatens an uncontrolled hemorrhage of your account equity?
Unfortunately this happens with about 15 or 20% of our trades and our ability to keep these losses within a normal distribution pattern is what makes or breaks us as traders. This is a particularly critical issue if you are using Systems without stops on day of entry.
If you subscribe
to my ideas about random markets you must understand that just about anything can
and will happen when trading markets. The imperfect market theory clearly allows
for aberrant price behavior. You as a trader need protection from
this.
Out of frustration I developed a simple strategy that probably works better
than anything I ever developed. If you are sick of always having your stops run,
this simple strategy is going to be a big help. If you got into a trade based on
a longer time frame such as a time
frame based on daily data you need to develop a stop loss strategy that is based
on a shorter time frame.
For starters you
should kick up an intra-day bar chart on your on line computer screen and set
the bars to something like 3 to 10 minutes. If you are following our trading
rules you are going to buy when the market goes up. This upward movement should
create some kind of upward wave on the intra-day chart. You should measure this
wave from its top to its bottom and if you are long the market you should place
your stop at the point that represents a 75% retracement of that wave. If you
are short the market you simply
reverse the process.
Hence my rule for placing your protective stop is:
Place your protective stop at a point that represents a 75% retracement (5/8 or
6/8) of the wave/move that got you in.
Let's look at an illustration:
Here again you see why the "buying high" strategy doesn't sell systems. Buying point B (which is the high) looks like a terrible place to enter this market. Why not sell at point B? Or if we have to go long why didn't we buy at point L (which is the low)? Don't despair.
Because you feel that way others will feel that way also and so they, the majority of market players, won't buy because it's too scary. The market in the best tradition of the "Rule of the Screw" will sense this hesitation by the timid majority and move much higher. That will encourage the timid majority and they will then jump into this market in a buying frenzy.
At that time you will calmly sell your positions back to the frenzied majority and take your profits. The whole scenario looks something like this:
The point I'm making is that when you first get into these trades they seldom
look good and you need to use the 75% retracement rule to place a stop so as to
give yourself some peace of mind. If you go back and look at Figure 2 you can
see how this stop was calculated. I measure from point L (low) to point H (high)
and take 75% of that and subtract that from point H to determine the stop which
is equivalent to the price shown at point SS (sell stop).
If you are an Elliot Wave purist you may notice that there are other smaller
waves in figure 1. Try to keep it simple and try not to miss seeing the forest
for the trees. I'm not an Elliot Wave purist and what I do with a 3 to 10 minute
chart is to measure from the highest high after your buy point has been hit to
the lowest low on the screen.
Usually that is going to be the lowest low in the last day or two. That's what I
mean by "the wave that got you in."
The Fibonacci Connection
Some of you sharper readers may at this point notice that maybe I might really
just be playing around with Fibonacci ratios. Indeed what we are really saying
when we elect to place a stop at "75% retracement of the wave that got you in"
is that if the market fails to be supported at the 5/8 or .618 Fibonacci
retracement point, it becomes a "Fibonacci failure," a trend reversal and we
need to get out of the way of a collapsing market. Believe me you are going to
be very happy to be out of the market if these stops are hit and it will be very
unusual for the market to "tag" these stops and then move higher. This is the
most effective stop loss strategy we use.
Some of you technical analysts may at this point feel somewhat vindicated. Here
I am telling you first that technical analysis is a lot of baloney and then I
turn right around and start using Fibonacci ratios for stop placement.
Of course the ratio .618 wasn't invented by a technical analyst. It was known to ancient Greek and Egyptian mathematicians as the Golden Ratio or the Golden Mean and was used in the construction of the Parthenon and the Great Pyramid of Gizeh.
Summary and Conclusions
These "laws" (If Prices move up there is greater probability they will move
higher rather than lower; If prices move down there is greater probability that
they will move lower rather than higher) are permanent, will not break down and
cannot change in the future.
Once we have entered a trade based on these rules we will reject traditional
"stop and reverse" and "trailing stop" strategies of exiting our trade. Instead
we will:
Take profits only when the market is moving strongly in our favor and place our
protective stop at 75% retracement of the wave that got us in.
Some of you may at this point be ready to reject these market theories as being
far too simple to be useful. Before rejecting these theories, however,
I want you to scroll down and look at my equity curve for
seven years. Look at the summary of my monthly profits from January 1, 1989 when
I became fully automated, through June, 1991. Look at the consistent income and
small drawdowns.
How many gurus do you know who have included seven years of real-time trading
records along with the materials they are selling?
I learned these rules in the marketplace and while attending the "School of Hard
Knocks." On the surface they may seem simple, but implementing them in the
marketplace is a more complicated process.
Later I will show
you how you can consistently gain an
edge on the markets and automate a trading system using these same simple rules.
Using these strategies you need not fear that these basic rules will break down
or stop working. They can't stop working anymore than Newton's Law of Gravity
can stop working.
In order to understand market movement you must understand the imperfect market theory and accept that most short term market movement is random and unpredictable. That is the bad news. But the good news is that imperfect and random markets can be integrated into our short term stock trading systems and we can still make money.
You must also understand that technical analysis is useless for analyzing this kind of price movement. Garbage in and garbage out. I believe if we stop looking at all those wiggly lines, charts and complicated formulas and concentrate instead on simple up and down price movement we can beat the pants off the big boys. Call this back-to-the-basics trading or call it anything you like. I call it financial security:
