Tuesday, July 26, 2011

Trading Rules: Speculate vs Forecast vs Trading

You are only ready to speculate when…

    * You have an emergency fund of atleast 3 months worth of expenses set aside in a bank account that you will not touch
    * You have a steady income that exceeds your expenses
    * You are fully contributing to your company 401k plan or 403b or have fully funded your IRA
    * You have sat down and developed a investment plan
    * You have backtested your trading strategy and have reasonable expectations
    * You are mentally prepared to lose some of your money
    * You have saved enough surplus funds to begin investing

Trading vs. Forecasting

Trading has made you money. Trading is not forecasting.
Trading is all of these:
   1. Selection (choosing your instrument)
   2. Timing (entry and exit)
   3. Money Management (position sizing, stop loss protection etc.)
   4. Psychology (controlling one's emotions)

Forecasting is:
Cycle analysis (seasonals, fixed, expansion and contraction), gann wheel, empirical models, Non-linear models, Fibonacii time/price projections etc. to arrive at likely CIT times and prices. Forecasting is a skill which when used properly impoves item number two on our trading list... timing. It also can help with item 4... psychology, by improving our confidence (provided that expectation kept in stochastic perspective). Last but not least, forecasting is fun.

Timing (and in turn forecasting) is the least important aspect of trading. Katz and McCormick (in their book: Encyclopedia of Trading Strategies) proved that (in theory) traders can make money even with a random entry is used. Why used a 200 dma when a flip of a coin will do?

Any respectable Technical Analyst will advise you against trading the forecast.

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