Which has a greater chance of happening?
A stock going up?
A stock going up because hedge funds are buying it in the belief that earnings are going to be much higher than expected?
In trading we deal with probabilities, yet humans, even many statisticians who (are supposed to) know this stuff inside and out, struggle with probabilities in daily life.
The stock going up is the more probable outcome, because it could go up for hundreds of reasons, while the hedge funds buying it up based on big earnings potential is only one of those hundreds of reasons.
While most of us nod our head in agreement once we find out, it is extremely hard to get away from.
Almost every analyst we see on CNBC or read online gives their outlook (up, down or sideways) for a stock or forex pair and then proceeds to explain why. We need to understand that the reasons (nearly all the time) given don’t improve the odds of the stock rising (To see how market truisms are often wrong, see: The “Action-Reaction” Model: Another Trading Mistake)
Even if the stock does rise it may not have risen for the reason the analyst gave. The analyst could have given an elaborate explanation about rising earnings, RSI readings and Bollinger Bands, but the stock actually went up because I spilt coffee on my keyboard and in cleaning it up accidently bought 100,000 shares which caused other traders to think a major player was starting to buy the stock, and so they started buying themselves.
There is one major take away from this, and also a caveat.
The major take away is that the simplest explanation is the most powerful, because it encompasses all explanations which are more precise. Simply saying a stock will rise has a greater probability of occurring than explanation as to why it will rise.
Here’s the caveat. Certain types of evidence do seem to strongly correlate with better than average trading returns. Think of it like a court room. If a man is on trial for murder and a witness says “I only saw it was a man who killed her” doesn’t add much evidence that it was this man on trial. His DNA at the crime scene may be a crucial piece of evidence though.
So we need to always ask ourselves (whether in our own trading, or watching someone on the news), “Is the evidence being presented actually relevant to the case being made?”
In order to figure that out, you need to test. Do RSI overbought and oversold levels really help you make better trading decisions? Test it out, or find someone that has. Are candlestick chart patterns reliable? Look for stats to back it up. Only then do you know if it is valuable evidence for discerning stock prices and making profitable trades.
Do this for a number of indicators and you’ll find that very few will help you with your trading. Most indicators react to price, their calculations have absolutely no predictive qualities written into them.
Now there do seem to be some things I have found which tend to turn prices, with slightly better than average odds. By combining support and resistance (usually diagonal in the form of trend channels), trading in the direction of the trend, and occasionally watching Fibonacci Retracement levels related to those trades, I am able to pick some advantageous entries. Yet even so this is a slight edge, which I exploit by taking lots of good set-ups in multiple forex pairs so that most work out, but a few won’t. I don’t know which ones won’t work though, which I why I take as many good set-ups in different pairs that I can.
Don’t get drawn in by other traders giving you all sorts of reasons for why a stock or forex pair will go up or down. Only price tells the real story, so watch price. Most “evidence” may not even be correlated to better than average returns, but because someone said it, and it seemed to make sense, it is repeated over and over again. It could be a total lie, but no one has bothered to refute it. Even if a strategy/evidence works for someone else, you don’t know if it will work for you. So test things out for yourself before relying on someone else. Piling evidence, especially when most of it is BS, won’t improve your odds of trading successfully.