Many new traders ask me if the market is random or not. My answer is yes, of course, the stock market is random if you mean that anything can happen at any moment. A subsequent, and understandable, question from many of them is, “How then can we make money in such a market?”
The answer is that although the stock market is random, there are certain trading patterns that appear almost every single day, and as a trader your job is to find and properly trade those. However, finding a pattern is not enough, an excellent execution is just as important. I often in the chat find and call out many potential trading patterns to traders, but I do not take them myself. When I am asked why I’m not taking the trade, my answer is that I could not find a proper risk/reward ratio in order to make the trade.
To illustrate this point, let’s think about the sky. When our ancestors originally studied the sky above them, they saw what appeared to be a random mass of stars. As they continued their observations, however, they came to realize that specific patterns of stars were always present. And not only were they always present, they were also so consistent that people could actually establish calendars and chart navigation based on those patterns. Of course, we know now that the sky is not random. It is based in the forces of gravity. The point that I am trying to make is that this is quite similar to the stock market. Prices go up and down, and anything can happen at any moment, but there are certain patterns that show themselves over and over again. And the good news for traders is that there's a good chance you can actually make money by recognizing those trading patterns.
Your job as a trader is to find those patterns and then execute good trades that are based on them. Sometimes you will recognize an opportunity, but if you decide to invest too much, you could lose money. Or, if you hesitate a little bit and get a bad entry, you could also lose money. This means that recognizing trade patterns is important, but execution is equally important.
The bottom line is that although the market is random, it is possible to make consistent money from it, similar to how our ancestors learned to navigate and measure time from what appeared to be a random sky. However, you need to be prepared for the unforeseen in the market. When you enter a trade, there is a possibility that the trade will go against you. That is why you must use stop losses and exit losing trades. This is the confusing part for many people. They do not know how to accept a loss, but they still believe the fact that making money in the market is possible.
Another important aspect of trading is understanding the risk and probability that is inherently involved in it. Trading is a game of probability and statistics. If you execute proper risk/reward trades, in the long term you will make more money than you will lose.
In the business of casinos, almost all of the games have a favorable ratio toward the house, meaning that the casino is more likely to win than lose. This does not mean that gamblers cannot or will not make money. No, every night in Las Vegas, millions of dollars go to gamblers, but a few more millions of dollars go to the casino owners, should sufficient people be gambling that night. There will be nights that the gamblers will make more money than the casino will, but at the end of every year, the casino will be the overall winner by some percentage. And that is why the casino industry needs more and more players. And that is why drinks are free and your food, hotel room, and flight to Las Vegas is so cheap. Why you ask? Because the real money for hotel and casino owners is in the gambling. The more people who play in the casino, the more favorable the odds are for that casino.
A great example to illustrate the difficulty in grasping the concept of chance and probability is a famous brain teaser and puzzle known as the Monty Hall problem, which is discussed in Jack Schwager’s book, Market Wizards. In 1963, a television game show called “Let’s Make a Deal”, hosted by Monty Hall, premiered. Suppose you're on the show, and you're given the choice of three doors: behind one door is a big prize like a new car; behind the others, goats. Of course, everyone wants to get the big prize! You have to pick one of the three doors. You pick door no. 1, for example, and the host, Monty Hall, opens another door, door no. 2, which has a goat. Monty Hall, who was also one of the creators and producers of the game show, knows which door the prize is behind. The way he played the game, he would never open the door with the real prize. Now he turns to you and asks, “Do you want to switch to door no. 3?” Do you stay with door no. 1 or do you switch? Is it to your advantage to switch your choice?
The obvious answer seems to be that it doesn't make a difference. When you picked door no. 1, the chance of winning the big prize was equal to one-third or 33%. Now you have only two doors, and everyone thinks it must be a 50/50 chance between the doors, and so changing from door no. 1 to door no. 3 does not make any difference. You have a 50% chance with either door.
But surprisingly, this is the wrong answer. The correct answer is that you should always switch to door no. 3. The probability that the prize is behind the door you originally picked was one-third, 33%, and in being behind one of the two doors you did not pick was two-thirds, or 66%. The fact that Monty Hall opens one of those two doors and there is nothing behind it doesn't change this original probability of 66%, because he will always open the wrong door. Therefore, if the probability of the prize being behind one of those two doors was 66% originally, the probability of it being behind the unopened of those two doors is still 66%. So, if you stick to your door no. 1, you have a 33% chance of getting the big prize, but if you switch from door no. 1 to door no. 3, you now have a 66% chance of winning the big prize, instead of the 33% chance if you stick with door no. 1.
This show was watched by millions of people for years, and yet many did not realize that the odds were so heavily in favor of switching! What confuses people is that the process is not random. If Monty Hall randomly chose one of the two doors, and the prize was not behind the selected door, then the probabilities between the two remaining doors would indeed be fifty-fifty. Of course, if he randomly selected one of the two doors, then sometimes the prize would be behind the opened door, but that never happened. The key is that he didn't randomly select one of the doors; he always picked the wrong door, and that changes the probabilities. It's a classic example of conditional probability. If the probability of the prize being behind door no. 2 or door no. 3 is two-thirds, given that it's not door no. 2, what is the probability that it's door no. 3?
The answer, of course, is still two-thirds.
One reason people have trouble understanding the correct solution to this puzzle is that the problem uses only three doors. This makes the assumed, but incorrect, probability of picking the big prize (1 in 2 or 50%) appear too close to the actual probability (1 in 3 or 33%) and the solution difficult to be grasped intuitively. To illustrate this better, suppose the game was played with 100 doors, goats behind 99 doors and a car behind only one of them. When first offered a door, a player would realize that the chances of picking the car are low (only 1 in 100). If Monty Hall then opened 98 doors and each had a goat behind them, it would be clear that the chance the car is behind the remaining unselected door is high (99 in 100 or 99%). Although only two doors would be left (the one the player picked and the unopened door), it would no longer intuitively appear that the car is equally likely to be behind either door. The costumed contestant originally had a 1% chance, and now they cannot say doors no. 1 and no. 100 still have the same probability. To change the pick would be intuitive to most people.
Of course this problem assumes people prefer a car to a goat. However, some might argue that a goat is a delightful animal, and finding parking in most cities is a problem.
The bottom line is that your intuition deceives you. Your simplistic impulse is to say that the probabilities are 50/50 for both door no. 1 and door no. 3. On careful analysis, however, you realize that there is a huge advantage to switching, even though it was not at all obvious at first. The moral is that in trading it's important to examine the situation from as many angles as possible, because your initial impulses are probably going to be wrong. There is never any money to be made in the obvious conclusions.
This example demonstrates that many people cannot find peace and accept that there will be losses when trading. Instead, they start questioning their strategy, their training, their ability and their skills, rather than accepting that a loss is a part of the process. They do not realize that a loss in trading is not personal, it’s simply to be expected from time to time. It’s part of the normal probability and uncertainty associated with the markets. It’s the same as the people who did not realize that they had a better chance of winning if they had changed from door no. 1 to door no. 3. They also did not have a good grasp of the concept of probabilities.
In trading, you accept a loss, without questioning your strategy. You make another trade, and you accept another loss, and in the third trade, when it works in your favor, you make sufficient money to cover your previous losses, if you are using a risk/reward ratio higher than 1:3 in the execution of your strategy.