Risky or Reckless, Are You Gambling in the Market?
Stockscores.com Perspectives for the week ending August 8, 2008
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In this week's issue:
There are many who consider trading the stock market to be a form of gambling. Quite truthfully, the way many people trade the stock market it is a form of gambling. Legal, easily accessible and perhaps more addictive than a slot machine, I have seen many people suffer great financial loss in the pursuit of easy market profits. How is it that trading can be gambling for some and a legitimate income source for others?
Because, for most, the value of the outcome of their trades in not known before the trade is made. We all understand that what happens with stock price is uncertain but that does not mean it is not predictable. A gambling trader may hope that he or she makes money on their trades but the professional trader knows what he expects to make on the trade. They know the expected value of the trade.
Suppose you devise a trading system that says buy any time the 20 day moving average crosses above the 40 day moving average and the volume is at least double the 20 day volume average (I have no idea if this is a good strategy, I doubt it so don't try trading it). You then test your trading strategy along with some rules for exit and find that, over a sample of 300 trades, the average profit was $410 and the average loss was $230. Profits happened 67% of the time so, of course, losses occurred 33% of the time (again, all hypothetical).
The pro trader recognizes this as a money making system (it should be noted that the statistics above are not all that a person needs to consider when assessing whether a strategy is effective, I just want to keep it simple for this discussion). The expected value of a trade is as follows:
Probability of profit times the average profit - the probability of loss times the average loss so for this example;
0.67 times $410 - 0.33 times $230 = $198.80.
The trader who does this analysis finds that this simple strategy is expected to make them $198.80 each time they make a trade. While they do not know if the next trade will be profitable or not, they can predict what the profit should average out to over a large sample of trades, provided that what has happened in the past continues to happen in the future.
So, let me now ask if you know the expected value of the trades you make?
If you answer no then you may be a gambler. I say may because some traders may not have tested their rules to know the expected value but have still proven in their actual trading history that their strategy has a positive expected value.
In short, if you have no idea if your trading rules actually work or if you don't even have a set of rules, relying instead on gut feel, then you are gambling at the stock market casino. Sadly, this casino will not comp you a room or give you free drinks when you play.
Successful trading involves taking risks; we are probably never certain of what the outcome of our next trade will be. Taking risk is necessary if we are hoping to make a return. However, there is a difference between taking risks and being reckless.
Think about what it means to be reckless. I like to mountain bike, race cars and fly planes; all things that most consider to be risky. But when I am on my bike, I don't try to do 75 foot gap jumps like Matt Hunter, I don't go 200 mph in to a corner like Lewis Hamilton, I don't do wing to wing aerobatic maneuvers like the Snowbirds. I work within my abilities and limits and in doing so, avoid letting risk turn in to recklessness.
Buying a stock without knowing the expected value of the trade is reckless, it is gambling. Additionally, what is a simple risk for one person may be reckless for another. You have to know what your limits are and work within them. I may trade a strategy which has a positive expected value and not be reckless but if the experience required to execute that strategy is beyond your limits then trading it for you would be reckless.
If you want to be a successful trader you have to stop gambling and make sure you are trading with an expected outcome that is positive. You need to work within the limits of your skills and experience and avoid being reckless.
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This week, I again ran my favorite Stockscores Market Scan for position trading, the Stockscores Simple. It looks for stocks that have good Stockscores indicators and may have good chart patterns. From the list of stocks that the Market Scan highlights, I look at the charts with the Gallery Chart Viewer to see if they have the right chart pattern and a favorable risk reward expectation.
There were many more stocks this week than in the recent past, an indication that market conditions are improving, particularly in the US. Here are a couple of names that I think have good potential:
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1. T.RBA
T.RBA also trades on the NYSE as RBA. The stock had a quick jump higher late in April when the company split their shares, but generally has been trading below $28 a share. The stock broke out through that resistance on Friday with abnormal volume supporting the move, indicating some excitement among the buyers. Support on the TSX listing at $27.
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2. MCD
The US is in a recession, perhaps that means less Filet Mignon and more Big Macs. MCD is breaking out through resistance at $62.50 with strong volume, it looks like it wants to start a new upward trend from here. Support at $57.50.
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References
Get the Stockscore on any of over 20,000 North American stocks.
Background on the theories used by Stockscores.
Strategies that can help you find new opportunities.
Scan the market using extensive filter criteria.
Build a portfolio of stocks and view a slide show of their charts.
See which sectors are leading the market, and their components.
Disclaimer
This is not an investment advisory, and should not be used to make
investment decisions. Information in Stockscores Perspectives is often
opinionated and should be considered for information purposes only. No
stock exchange anywhere has approved or disapproved of the information
contained herein. There is no express or implied solicitation to buy or
sell securities. The writers and editors of Perspectives may have positions
in the stocks discussed above and may trade in the stocks mentioned. Don't
consider buying or selling any stock without conducting your own due diligence.
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