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Hello RT,
Lately there have been a lot of mails about mechanical trading systems and
what types of indicators make a perfect system. I would like to share my
opinion on trading systems and markets they are trying to predict. Let me start
with a story which took place at the floor of the CBOT.
"Soybeans were sharply higher. There was a drought in the Illinois Soybean
Belt, and unless it ended soon, there would be a severe shortage of beans....
Suddenly a few drops of water slid down a window. "Look," someone shouted,
"rain!". More than 500 pair of eyes shifted to the big windows... Then came a
steady trickle which turned into a steady downpour. It was raining in downtown
Chicago.
Sell. Buy. Buy. Sell. The shouts cascaded from the trader's lips with a roar
that matched the thunder outside. And the price of soybeans broke like some
tropic fever. It was pouring all right, but no one grows soybeans in Chicago. In
the heart of the soybean belt, some 300 miles south, the sky was blue, sunny
and very dry. But even if it wasn't raining in on the soybean fields, it was in
the heads of traders, and that, is all that counts."
So what's the moral? Fear! The trader were afraid. Afraid that the rain might
turn the market against them and unconsciously contributed to this very fear.
NO trading system, how ever advanced, could have anticipated this 'irrational'
decision.
Fear drives the market. Fear of not following the crowd; fear of being on
the wrong side of the market; fear of missing a trade; fear of being stopped;
fear of forces of nature ruining your perfect bet, fear of not getting you order
filled.... You must have heard the veteran traders saying that a trader should
be disciplined. In other words, he should be able to control his fear and act
rationally.
But markets are people. Fear is an important part of human psychology. And
fear - does not compute very well. The vast number of mechanical trading
systems available today, try to anticipate almost all the possible aspects of
trading; but do they have a fear indicator which might alert the trader that this
time, market may not behave the way it 'should' as it 'did' last time when the
conditions were similar.
If someone can come up with a mathematical model which represents the
market psychology, there will be no loosing trades at all. All those time when
your $3000 trading system said "BUY" and the market broke through your
stop like a mad bull, you can rest assure that it was due to something which
could not be incorporated in your system. Statistics and mathematics can
build a trading system, back testing the system can give it a touch of some
realism. But THAT is history with no emotions (fears) to challenge its signals.
In real life, market is NEVER obliged to follow its speculations.
I am not against mechanical systems, but they should not be trusted blindly.
Like John Manyard Keynes said, "there is nothing so disastrous as a rational
investment policy in an irrational world."
CONCLUSION:
a) You should not follow your system blindly, as it is not designed to cover the
"irrational" side of trading. You should use your discretion when you smell
that 'something' which your system is unable to compute.
b) Fear is an important ingredient of the market. It should be understood in
order to understand the underlying markets.
Regards,
Mubashir Nabi.
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