Innovative Trading - Day Trading
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Innovative Trading - Day Trading

HOW THE MARKETS REALLY WORK

“It is remarkable that a science which began with the consideration of games of chance should become the most important object of human knowledge ... the most important questions of life are for the most part only problems of probability.” --Pierre Simon De La Place

Theorie Analystique Des Probabilities 1812

Take a coin and toss it into the air. As the coin spins in the air you have no idea and cannot predict which way it is going to fall. Yet over many tosses the outcome can reasonably be predicted. Just as we can predict the tosses of a coin with probability, so too can we use probabilities to predict market direction. When you trade you need to trade with the probabilities and odds in your favour.

In recent years many academics have scoffed at the idea that markets can be predicted and they point to the theory of Random Walk. The theory is based on the assumption that markets are efficient. The market is one where a large number of equally well informed people actively compete to try and maximise profits. In such a market, at any time, the price will reflect all available information as well as all events expected to occur in the foreseeable future. The theory holds that as all current and future events are discounted, the individual’s chances of over performing or under performing the market as a whole are even, i.e. you can never put the odds in your favour, and therefore will not be able to earn consistent profits. If the theory is correct, our rules and all our trading efforts will count for nothing.

It is amazing this theory has become so widespread and so many people believe it. It is, however, completely incorrect as it assumes that the decision-making process conforms to scientific theory. It quite clearly does not; the facts are there for all to see. However, we all make personal subjective judgements based upon our knowledge, understanding and emotions. Given the same information, we do not all reach the same conclusions.

If we discount the Random Walk theory and say that human behaviour is unpredictable, then how can we put the odds in our favour? The answer lies in probabilities discussed earlier. To trade the markets you need to trade to minimise risk, and maximise gains. The way to do this is to catch the trend. Take any chart over a period of time and you will notice trends and recurring patterns. If all humans think differently, how and why do these patterns emerge? The answer can be found in the theory of “chaos”, which postulates that certain types of natural activity are chaotic except in terms of probability. To give an example, the heartbeat of a person can be charted but given certain conditions, a heart will go into random fibrillation during which time the heartbeat cannot be predicted or modelled. Mathematically, weather forecasting is another area where chaos theory applies. The unpredictability of weather forecasting comes from what is called sensitivity to initial conditions. Mathematical models fail in forecasting because the slightest divergence between simulated and actual conditions multiplies in a complex chain of cause and effect relationships, giving rise to results in the model totally different than in nature. The best meteorologists can do is to forecast weather within the limits of probability.

While admitting that certain events in nature don’t follow a perfect mathematical order, chaos theory says that they can still be understood, predicted and controlled. It directly challenges Random Walk that there is no way of predicting market movement. There are no certain predictions but there is order to the chaos, and forecasts can be made on the basis of probability. To understand probability in financial markets, we need to look at the psychology of the participants.

WHY CHAOS THEORY IS SO IMPORTANT.

“The organisation of the Universe demands that matters abandon itself to the games of chance.” --H. Reeves - Atoms of Science

The theory of chaos is not a theory to help you make investment decisions, its usefulness lies in the greater understanding it gives us of the trading environment and how we should cope with it.

1. It shows us how human psychology influences price movement, why trends occur, and how they can end up being understood in terms of probability. The herd mentality is fully explained in our Special Situations Report available from the office. Human psychology has remained constant over time, and it is this fact that helps us predict the probability of price movement via technical analysis.

2. It disproves Random Walk theory; although market movements may appear random, under statistical tests they are not.

3. If it disproves that the markets are random, it also shows why the quest for the “Holy Grail” computerised or mechanical trading system is doomed to failure. It also confronts those disciples of such analysts as Gann and Elliott who believe the Universe is ruled by law.

4. It helps us to operate in an unstructured environment by giving us a greater understanding of it. The best you can do is understand the original conditions that give rise to probable future events, and act accordingly. This may sound disheartening, it is not. By understanding chaos, you will be able to keep the odds firmly in your favour. If you can do that, you will end up making a lot of money from your trading, year in year out.

THE MADDING CROWD

“Whosoever be the individuals that compose it, however like or unlike be their make of life, their occupations, their character, or their intelligence, the fact that they have been transformed into a crowd puts them in possession of a sort of collective mind which makes them feel, think and act in a manner quite different from that in which each individual of them would feel, think and act were he in a state of isolation.” --Gustav Le Bon 1897

Chaos theory postulates that we can make accurate predictions in terms of probabilities and this is certainly true of market behaviour. Although all investors think differently, in the investment arena people change in crowds. In crowd’s investors, as a whole, react to their emotions rather than their intellect, and it is these basic instincts that can be predicted and controlled by those investors able to stand aside from the crown and think in a rational manner.

Typically a bull market starts in a period of uncertainty or fear. As more buyers enter the market, prices rise and confidence appears. As prices rise, the more greed and hope that prices will continue upwards for the foreseeable future. After a period everyone has bought, and there is no one left to push prices higher, a small number of investors exit the market, fear emerges, and there is a mad scramble to exit the market. This scenario to a greater or lesser degree occurs in all investment markets.

1. Human nature in investment markets on mass is constant and repetitive over time.
2. Investors tend to be followers, not leaders, and this causes trends to develop.
3. Investors tend to generally exhibit the basic emotions of greed, fear and hope when making investment decisions.
4. The more bullish or bearish the market becomes, the greater the probability of a reversal.

Human nature has remained constant for thousands of years, and although all humans think differently, the influence of the crowd allows us to predict market turning points and market trends with a degree of accuracy. I have covered the predictability of man’s investor behaviour in greater detail in my “Special Situations” essay, which should be read in association with this work.

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