Friday, May 23, 2008

The Probability of Profitability

Let us understand technical analysis in a different way today. We always knew that technical analysis is the study of charts and trying to predict the future. But does it work? Is it accurate? How often does it work? What is the probability of making a profit every time? What is the probability of being profitable after a year? Well, we have all the answers here. Come, let us understand probability in very simple terms.

We all have been studying since grade 6 that probability means the likelihood or chance of an event happening or not happening. We all know the example of the flipping of a coin and throwing a dice or drawing a card. For those who don’t know, here it is. When we flip a coin, only two possible things can happen. Either we get a heads or a tail. Since there is one chance of getting a heads out of 2 outcomes, the probability is ½ or 0.5. Similarly the probability of getting a six on the throw of a dice is 1/6 or 0.1667, the probability of drawing a card of hearts from a pack of cards is 13/52 or 0.25 and the probability of drawing an ace is 4/52 or 0.0769.

But, have we ever thought what is the probability of making a profit if we pick up a stock at random? Let us see what the possible outcomes are when we buy a stock. It can either go up or come down. Which means the probability of making a profit is ½ or 0.5 or 50%, which is a very high probability. Then why do we do so much of research and ask people to give us tips or spend hours looking at charts? Just for a simple reason that we want to increase our probability of making a profit to 0.7-0.8 or 70-80%. But, does it help us? Are we able to increase our profits? Actually speaking, no. Believe me, we are still better off picking up stocks at random and let the probability remain at 50%. I will give you a very simple formula. You pick up any stock at random, have a well-defined exit strategy and an equally well defined profit booking strategy. Let us say that our rules are that we will pick up a stock at random and book a profit if the price goes up by 10% and keep a stop loss 5% below our purchase price. Believe me, with such a strategy, you will never never make a loss.

Is the above system acceptable? It is not very difficult to follow. All we have to do is to book our profits and losses as defined by our rules. I am sure, we can all follow these simple set of rules to make profits. But, before you go ahead and implement it, let us talk about the drawbacks also. Over the years that I have been involved in the stock markets, I have not only studied technical analysis, I have studied human psychology too (as it works in the stock markets). I have learnt that the drawbacks lie in your mind. Firstly, you will never be able to come to terms with the fact that you have made money. You will always be thinking that it was this system that made money. The thrill of investing in the stock markets will be missing because the decisions are automatic and not your own. Secondly, you will be tempted to book profits at 9% (or lower) instead of 10% while when it comes to executing your stop losses, you will be reluctant to do so even at 8%. Thirdly, the returns are too low – only 2.5% on your total investment. You get more in a savings account. And last, the system will work well in bull markets and will be terrible in bear markets. God save you from the bear markets if you follow this system.

So, is fundamental option the best option? Well, it does help. But it has its own drawbacks. Fundamental analysis tells you whether to buy or not to buy a stock. But it has no clearly defined entry and exit strategies. So, you may never know when to book profits and when to cut your losses. The human psychology is such that it forces you to take your profits quickly before your profits turn into losses. And if you are in a loss, you will keep riding your losses because you are thinking that you had done proper research and that sooner or later the price should follow the fundamentals, so you keep holding on to your losing positions. No doubt, on some stocks you can get profits many times your investment but in some you could lose a lot too.

That leaves us with technical analysis. Technical analysis has well defined entry and exit levels and with proper discipline you can continue to ride your profits and cut your losses early and you can make a lot of money. But like any other method, this has its own set of drawbacks. The hit rate is not very good. If you choose 10 stocks, it is likely that only 3 or 4 calls out of those 10 will come out to be correct. But the advantage is that those 3 or 4 calls give you enough profits to cover not only all your losses from the remaining 6-7 calls but also gives you enough profits to give you a good return. Many technical analysts keep trying to develop methods which will give maximum profits. I am currently developing a system which will give me small profits but the hit rate would be between 85-90%. The details of the system are ready and I am currently testing it with my own money to fine tune it a little and it can then be given to a few selected subscribers who are disciplined enough to follow it and once they have also tested it for sometime and some more fine tuning is done, it can be shared with all others. This system, for convenience sake, shall be referred to as 'System A' from now on.

We should consider our trading to be a business. The objective of any business is to make money and that’s what will be the objective of our business. Like in any other business you will have some centers which will be your profit centers (which give you lots of profits) and some as your cost centers (which earn no profits but only cost you money). The objective is to maximize the profits from your profit centers and minimize the costs in your cost centres. Similarly, in this trading business there will be some stocks which will give you a lot of profits and some which will only give you losses. So, as long as you maximize the profits and minimize the losses, you will end up in a profit. And that is what technical analysis helps us achieve. Helps us to ride our profits and minimize our losses.

We have learnt today that there are many methods which help us to make profits. But all of them have their own advantages and disadvantages. Within Technical Analysis (which I consider to be the best, though this is a debatable topic) too, there are many methods but the
Dow Theory is the oldest and the easiest method of technical analysis. According to Martin Pring, as mentioned on buddycom, if an investor had invested $44 in the Dow in 1897 and liquidated his position after 93 years in Jan 1990 (pure buy and hold strategy, as happens in fundamental analysis), he would have got $2,500 after 93 years i.e. 56.82 times his investment, while another investor who invested and liquidated at the same times and who sold on every sell signal and bought on every buy signal would have got $51,268, a whopping 1165.18 times of his initial investment. That is the power of technical analysis and that shows how our probability of profitability increases with technical analysis. And technical analysis requires only one skill. Discipline.

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Happy Investing!!!