It is the time of the year when people make new resolutions and want to make changes in their life.
For many traders one of the resolution is to become a better trader.
If you are one of those trader then the first thing you need to do is to focus on concepts.
First focus on concepts
The most critical thing in trading is basing your trading strategy on a proven core concept.
The theory behind the concept should be logical and based on empirical evidence.
If the core concept is sound and based on proven anomalies rest is all about tactics.
Tactics is the easy stuff and can be adopted to suit your own needs.
Last night I was reading a book on psychology, where they talked about a learning experience where two sets of people were exposed to a method to do a task.
First set was first explained the concept behind the method and then taught the steps. Second set of people were taught only the methods. The first set outperformed the second set on the task.
Conceptual understanding is extremely important. It lays the foundation for long term success.
If you understand a concept, you can use several tactics or methods to achieve the same objective.
If you understand the concept behind Episodic Pivot then scans, software, entry, exit, target, etc. is all about tactics.
You can develop your own tactics and don't need to follow my scans or methods.
Get out of technical analysis jungle
In order to trade the markets successfully, you must have some overall understanding of what works in the market.
In last 30 years or so there has been lot of progress in understanding the markets.
Most of the advances in understanding the markets have been because of lot of academic professionals and quants studying the market as science. Such studies have contributed to our understanding of what factors drive stock performance in short term and long term.
Last 20-30 years have seen heavy adoption of such science driven approach by traders and wall street houses.
Quants have replaced the technical analysts and other old approaches, while retail traders continue to be still fascinated by the old approaches.
Technical analysis is about tactics it is not about strategy.
Evey year 100 plus books are published on technical analysis. They contain same information.
So why do you think traders still struggle. Because they lack right conceptual foundation.
How to make technical analysis work
If you overlay tactics on right concept it can work.
Absent that you are likely to struggle.
Does CANSLIM uses technical analysis. Yes. But is the central idea behind CANSLIM chart patterns. No.
Same way if you understand the concept of value investing, you will find good value stocks.
After that you might enter them based on technical analysis.
If you understand the concept of momentum and internalise it, then you might use chart patterns to narrow your momentum generated list.
First thing I would advise a novice trader is get out of the technical analysis jungle. First build conceptual foundation.
What works in the market
Based on the academic and quant studies of markets few basic trading approaches have evolved.
Most commonly followed trading approaches are:
- Momentum: momentum methods are based on price behaviour. Within momentum basically two types of approaches have evolved :
- Trend following: in which you make a trade in the same direction of a defined price trend.
- Mean reversion: because ultimately all trend end and trend start from weakness, mean reversion traders try and buy anti trend. Mean reversion strategies have become very popular with very short duration traders. Some highly liquid instruments like index futures exhibit very high degree of mean reversion during certain periods and are popular with short term trades.
- Growth: Growth investors buy stocks of companies with rapidly growing earnings or sales. the key to success in growth investing is being early in identifying a growth stock. Growth in companies tend to trend and that is why growth strategies work. In short holding periods of 3 to 12 months growth investing tends to do well.
- Value : Value investors basically look at ratio of price to some value indicator like earnings, book value, cash flow, sales, etc. So value investors look for undervalued securities. Research has now identified factors which drive valuation and have shown over longer holding time frames value strategies do well.
- Balance Sheet quality: Lot of academic research is now focused on real earnings and real growth as against managed earnings or managed growth. The complexity in accounting practices have resulted in most companies resorting to having two books of accounts: one for investors and one for tax and legal purpose. So there has been a growing trend towards managing earnings and balance sheet to satisfy investors. This creates a problem of quality of earnings and in many cases such quality problems lead to later date implosion. Most banks and big companies like GE are poster children for such practices. So a growing body of academic research is focused on identifying factors which can warn investors of such hidden problems.
- Statistical patterns: With computing power becoming cheap and abundant there is a growth in statistics based techniques for trading. In such techniques past patterns are studied and then current situation is compared to it. So you will find lot of people predicting the next day move in market based on whether it was up 3 days in a row or down 3 days in a row.
All these approaches have theoretical and logical and behavioral support.
Focusing on core concept that work in market is key to building a profitable strategy.
Study the concepts used by mutual funds
If you study the approaches followed by mutual funds , again you will find they are primarily based on above concepts.
You have families of value funds, growth funds, and industry funds.
Within that funds specialize by size.
So you have large cap, mid cap, and small cap funds.
Mutual funds are the largest players in the market.
They have studied what works. Their products reflect their understanding of the market.
Because of their size they have limitations, but that is our advantage.
We can use the same concepts and due to our size we have more flexibility to trade them.