Retail traders patron saint is Bulkowski

I get lot of emails from readers of blog asking about various scans and patterns , but that is not a very important part in profitable trading. The basic concept is important. Scans are tactical tools to achieve the end results. Tactics can be adopted to market or can be changed.

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. Retail traders patron saint is Bulkowski and many have no understanding beyond chart patterns. In a way it is good. Market consists of all levels of people and for market to work you need both informed and uninformed traders.

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.

If you talk to quants, most of the work they do is focused on these approaches. All these approaches have theoretical and logical and behavioral support. If you based your trading approach on proven approach you increase your probability of success. If basic approach is right tactics can be changed.