"I contend that for a nation to try to tax itself into prosperity is like a man standing in a bucket and trying to lift himself by the handle." Winston Churchill

After stirring up the hornet's nest last weekend, I'm returning to some considerations for traders. Last weekend, I had the privilege to speak at the Trader's Library event in Chicago and was humbled to be in the company of legends like Dick Arms (creator of the Arms Index) who was inducted into the Trader's Hall of Fame and Charlie Kirkpatrick, a two time winner of the Charles Dow award. Conversations with these men and several of the other speakers provided an invaluable learning opportunity; one for which I am extremely grateful.

Among the topics of discussion was the concept of predictions. We hear and see so much in the media devoted to whether the markets have found a bottom and where the bottom might be, but the truth is no one knows. Prediction is little but speculation and has no value. Look how well the weather forecasters do. Tell me, is the market going to be up or down next Thursday? Six months ago, who predicted that Lehman Brothers would no longer exist? In his excellent recent book, Beat the Market, Charles Kirkpatrick quotes commentator and chief market strategist Barry Ritholtz as saying the SEC should require all analyst and pundit forecasts to publish the following caveat: "The undersigned states that he has no idea what's going to happen in the future, and hereby declares that this prediction is merely a wildly unsupported speculation."

All we can know is the past and the present. If I knew the future, I certainly wouldn't be trading stock and options, I'd buy a winning lottery ticket and be done with it. Yet, as I talk to coaching students, I regularly hear things like: "this will be a long term trade" or "I'll be out of this trade in a week" or "I know XYZ will come out with a good earnings report and the stock will rocket." I always ask: "How do you know that?" Predicting that we will be in a long term trade may be tantamount to saying I'm going to let my losses run no matter what. Predicting that we'll be out of a trade in a week may be the same as saying that I've decided to cut my profits. Predicting that a stock price will jump on an earnings announcement doesn't make it so. Often, in fact, even when relatively good earnings are announced, a stock price will fall.

As Mr. Kirkpatrick notes in referring to David Dreman's research which studied 78,695 earnings forecasts by analysts over a 20 year period from 1973 to 1993 only 1 in 170 forecasts were within 5% of any four consecutive quarter's actual earnings. Why do we continue to rely on such speculation?

As I emphasized in my own talk on Sunday, I emphasized, as I always do, that one of the keys to successful trading is to have an exit strategy in place before ever entering a position. That enables a trader to get out if he is wrong on direction. As I've regularly taught in past seminars, the strategy needs to be one that permits profits to run while creating a disciplined unemotional exit that initially is both clear and close to the entry. In that fashion, prediction no longer controls. The successful trader, instead, simply reacts to the price movement. Having a plan that incorporates money management, reward to risk potential and disciplined exit strategy can supply an edge that prediction doesn't. After all, even the best traders in history rarely win more than 50% of the time. The key, of course, is to learn how to make the profits from the winners significantly exceed the losses from the losers. Few retail traders enlighten themselves on how to do that. Hopefully, you are among those who do make that effort for without it you will continue with the vast majority who fail in their trading efforts.

Good Trading!
Bill Kraft

November 1, 2008

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