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Separating Hype from Reality: What To Look For In A Trading Service
By Dr. Steve Sjuggerud, President, Investment U
Friday, May 9, 2003: Issue #237
“The [trading] community is not much interested in the methods of science. Traders are greedy, and they crave action. What turns them on are promises of large gains with no work involved.” -William Gallacher from the 1994 book Winner Take All
“Turn $1,000 into a million in two months!”
“We made 500% in a day!”
“Our system is 90% accurate!”
I don’t know about you, but I get solicitations like these in the mail a few times a week. And the amount of mail talking up high-risk, high-potential-profit trading services seems to be increasing.
So how can you tell what is real and good from what is just hype? That’s what we’ll cover today
Big Bold Claims, Or Outright Lies?
“Our system is 90% accurate!” one advertisement will tell you. Whenever I see that, I’m immediately skeptical. I’ve found that most systems that are 90% accurate take very small profits, and stick themselves with very large losses. Consider a system that takes profits of 1% a month for 11 months, and then gets hammered with a 50% loss in the 12th month. Yes it was right over 90% of them time. But it lost a heck of a lot of money
How about “We made 500% in a day!” or “Three out of our last five trades made 500%.” These may be true as well, but what about the 10 trades before these? What if the 10 previous trades all lost 100%? Is that a good system?
“If you could do over and over again what we did on that one trade, you’d turn $1,000 into a million bucks in two months.” That may be true as well. The problem is, it is a huge “if.” Chances are, you’d never have two – straight months of huge winners with no losers.
What Exactly To Look For
Trading coach Dr. Van Tharp covered the topic of trading services in his most recent letter to his readers. He showed how to objectively check out trading services
Van’s basic conclusion, as you might expect, is that it all comes down to reward versus risk. For that, you really need to get the full picture of what’s happened in the trading service if possible, so you can analyze the reward-to-risk ratio.
A rule of thumb I use in trading is: My potential reward has to be at least three times my potential risk. If you’re willing to lose it all in a particular option, that means you have 100% at risk. If you followed my rule, you’d only trade if you were expecting a 300% gain or more.
I’m fairly certain that most people don’t think about their reward-to-risk ratio like this when they trade. But they should risking 100% of your money for a reward of 50% is not likely to lead to big profits. One thing I recommend to improve your odds of having a profitable system is setting a maximum acceptable loss. Even if you set your acceptable loss as wide as 50%, then you “only” need a 150% gain to keep your 3-to-1 reward-to-risk ratio (150% is still a lot to ask of course, but it’s much more attainable than 300%).
Also, you should ignore a “high probability winner” claim. The number of times a system wins is irrelevant. The bottom line at the end of the trading period is what matters. I’ve found that the very best traders are actually only right about 35-40% of the time. That may come as a shock to you, but it is the reality. What they do to be extraordinarily profitable is have their winners be significantly larger than their losers.
To put this into a simple “checklist”
* Check out the entire track record, if possible (use the Internet to verify it as best you can)
* Figure out your RISK versus your REWARD-what you can potentially make
* Don’t worry about the winning percentage-the end of the day (or year) is what matters
* Consider how much of the track record relies on one huge winner
* Consider if the track record is long enough to be relevant/useful
* Consider the cost of the service, both in $$ and in commissions and “slippage,” (see the Crib Sheet for a definition of “slippage”) as you’ve got to factor that into your profit potential.
What To Watch Out For
Unfortunately, too many investors don’t want to do the work themselves. They would rather take the easy way out and place their faith (and their money) in the hands of someone else’s “system” no matter how off base it is. It’s easier that way, but it’s also an easier way to the poor house. Consider the following:
“The total interaction of the sun, moon, and earth is the basis of all market movement. Nothing else has the potential for predicting markets.” – Trading guru J. Welles Wilder
With statements like that, it is hard for me to understand how Mr. Wilder is taken seriously as an analyst and trader. But he is any trading-software package you buy off the shelf has some of Wilder’s indicators built into it.
And according to the book Winner Take All by William Gallacher, you actually have to learn this type of cosmic garbage or you could be denied your license as a futures broker.
All futures brokers must pass an exam. The study material is the Futures Trading Course and Handbook. Quoting from Lesson 10 of the study material:
“Elliot observed that all natural phenomena are cyclical. And he set out to determine whether this cyclicality can be found in market price behavior. After several years of study he arrived at the conclusion that prices do move in waves”
But Gallacher blasts this “theory” in his book, saying: “There is little point in exploring the Elliot Wave Theory because it is not a theory at all, but the rather banal observation that a price chart comprises a series of peaks and troughs Elliot thought that a bull market consisted of five peaks interrupted by five troughs. Trouble is, no two people can agree on what constitutes a peak or a trough Much is made of Elliot’s observation that all natural phenomena are cyclical. But this is no more than a statement of the obvious.”
Going back to Lesson 10 of the study guide
“Elliot also discussed the so-called Fibonacci numbers, named after a 13th-century Italian mathematician. The Fibonacci series is infinite, with each number being the sum of the preceding two numbers: 0, 1, 1, 2, 3, 5, 8, 13, 21. Although reputedly designed by Fibonacci as an exercise for his students, the Fibonacci relationships have received close attention from statisticians – including commodity market technical analysts. Elliot’s totals for the numbers of major, intermediate, and minor moves in a bull and bear market are all Fibonacci numbers. Some technicians have devised entire trading methods based on the Fibonacci numbers.”
Gallacher again let’s ‘em have it “Elliot’s ‘wave’ and Fibonacci’s ‘numbers’ have long been favorites of [traders]. The arcane interpretations and mystical overtones appeal to a certain type of [trader] mind. Reading the examination material, I kept waiting for the punch line, the disclaimer, but it never came”
A few pages later, Gallacher sums up why people buy into this stuff: “The [trading] community is not much interested in the methods of science. Traders are greedy, and they crave action. What turns them on are promises of large gains with no work involved.”
I’ve spent my career on the “science” side of things. I see the markets as a big game, where you have to put all the pieces together better than the next guy. It just so happens that if you win the game, the reward is much more than Monopoly money.
People will adamantly believe in the phases of the moon, Elliot’s waves, and other stuff (I recently received a passionate 50-page letter a from a schoolteacher in Asia begging me to write about Elliot’s waves). I don’t care to try to change their minds.
As a very general rule of thumb, I’ve found that the simple stuff is what works best. The farther you get from the basic concepts of value and price action in the markets, the farther you’re getting off the trail.
When it comes to considering buying into a trading service, put it to the test of the checklist above. A little homework will pay large rewards-or at the very least it could save you a bundle.
Good investing,
Steve
Today’s IU Crib Sheet
- “Slippage” as used above is the difference between actual results and theoretical results: this can be the bid-ask spread, commissions or other costs associated with investing that eat away at your profits.
- If you want to learn more about what William Gallacher has to say about investing philosophies, click here to buy Winner Take All.
- Foreign Exchange Trading: The Emotional Discipline of Trading Forex
- This Swiss Logic Has More Holes Than Their Cheese
- What’s The Best Way Up?
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