How to Think about the Stock Market Scientifically
When evaluating the stock market, even the best indicator fails to work all the time. In fact, some of the best indicators work less than 50 percent of the time, and that’s when market conditions are normal! Critics use this awful statistic to say that technical analysis is a waste of time. This harsh opinion results from a failure to appreciate the benefits of risk management embedded in the technical trading style.
When you hear someone say, Blue Widget has a 75 percent chance of rising, you can assume that three out of the last four times the technical method was applied, the security rose. The unspoken assumption is that conditions didn’t change. But the market is not a laboratory. Of course conditions changed!
Your forecast needs to be qualified because of the thousands of factors that may come along and influence the price. Contingencies are things that are possible but not expected, or not expected in any great number at the same time.
When you hear a market maven predicting a price change with a 75-percent probability, chances are she’s talking through her hat. She may have failed to incorporate all the reasonable contingencies, or she may have attributed too small a probability to any of them (or to all of them).
Most technical traders hate to attach a probability to a particular outcome because they’ve realistically assessed the contingencies. In statistics, when you want to calculate the probability of two events happening simultaneously (called joint probability), you multiply their probabilities. If you have two remotely possible contingencies, each with a probability of 10 percent, the chances of both happening simultaneously is 10 percent times 10 percent, or 1 percent.
To calculate the effect of a 10 percent probability contingency on your trade, you take the reciprocal of the probability, or 90 percent, as the amount to modify the 75 percent. And if you have four contingencies to which you attribute a 10-percent chance each, you multiply each result by 90 percent. In arithmetic notation, it looks like this:
75 percent x 90 percent = 67.5 percent
67.5 percent x 90 percent = 60.75 percent
60.75 percent x 90 percent = 54.68 percent
54.68 percent x 90 percent = 49.21 percent
Introducing one contingency reduced the probability of your outcome from 75 percent to 67.5 percent. With four contingencies, the same process reduces your 75 percent odds to a mere 49.21 percent, which is less than 50-50.
Statisticians say you need a minimum of 30 cases before you can say anything valid about the probability of history repeating itself. Scientists who do really serious science, like missiles and moon shots, demand a minimum of 200 cases. Your price data seldom presents you with 30 cases, let alone 200. Why should you accept less? The answer is that you’re using a technical analysis method that works across a wide range of securities and time frames, even if you don’t have enough cases in this specific security.