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Foundations

DIT: Two-out-of-Three Elements for a Brilliant and Useless Prediction

There are just three elements to a market or stock prediction that make it useful and tradeable.

  • Direction: Which way will the stock go? Up or down?
  • Intensity: Will it fall 10%? 50%? A heck of a lot?
  • Time: How long will it take? Will this happen tomorrow or within a year?

Without all three, you can’t really make a trade. A market that will eventually rise 50% is a useless market to trade, because once you’ve gone past 10 years, you’re now fighting the savings bank rate (in India).

The important thing to note, for people who think they can predict a move successfully is to make statements that satisfy only two of the above three DIT elements.

For instance, you could say:

The market will fall in the next two days.

Markets will remain volatile, and they will have a high and a low – if the high is higher than the low, markets have fallen and you are right. You got Direction and Time but not Intensity.

Or, you might say:

Reliance Communications will rise 10%.

You’ve nailed the Intensity and the Direction, but the time frame is “Eventually”. Which means it could fall 50% and you’ll still say it’s going to go there someday, there is the “potential” or something like that. And you’ll be right.

And finally you can say:

There’s going to be a 5% move in real estate stocks in the next week.

Given any volatility metric, such a move is nearly guaranteed. However, this statement becomes difficult to justify if you make the percentage large enough to struggle to be right (like 10%, tomorrow). You’ve avoided Direction, and got the other two.

Technical note: Yes, you could trade this last one, successfully, using straddles.

My point is about the business of prediction. Those that make it a business, like TV channels or some market gurus, tend to give you the illusion of a good prediction, but they’re usually missing one of the D-I-T elements. It sounds good, but it’s useless, wastes your time, and excites the gambler’s instinct that is embedded in our DNA.

The other thing that happens nowadays is to make a very large number of predictions, even those that contradict each other. (Like Buy Suzlon and Sell Suzlon) Then, whichever way Suzlon went, you can point to the appropriate prediction and say you were right. If Suzlon actually didn’t move in any direction, you can rest easy that you made so many predictions no one will have the patience to check.

And then, there are the weasel statements like this:

Exercise caution at these levels, however it looks like a good long term opportunity.

If the stock goes down, you repeatedly emphasise the first part of the sentence. If it goes up, you take the second.

Eventually, markets are not about successful prediction. Markets are about successful execution. Execution, then, involves multiple elements:

Entry: This is the most hyped element but very important. The idea is to get in,but into what? And one-shot, or staggered? Is there a well defined reason that might be applicable to other stocks as well?

Position Size: You can buy a stock and be proud that it went up 10%, but what if you bet only Rs. 5,000 on the trade, and the 10% won’t even pay for your celebratory beer?

Exit: What parameters must you keep track of, before an exit? Is there a stop loss? Is there a time within which, if the stock does not perform, you’re out? Do you get out all at once, or let it be?

The execution elements give you nearly all of the return you make. You don’t have to predict – you need proper entry strategies. A prediction has a yes/no answer to being right; a trading strategy means that

a) If you are right 50% of the time

b) You should win more when you are right and lose less when you’re wrong

Venture capitalists use the extreme of this – they win once out of 10 times , but when they win they expect to make at least 20x of their money back; so all they have to do is to take the kind of entry that will give them 20x at least.

An arbitrageur might buy on the BSE and sell on the NSE at the same time, locking in the spread. He’s “right” 99% of the time, so he can make Rs. 1 per winning trade and lose Rs. 10 for a losing trade, and still make out okay.

The trend or swing trader tends to work with the 40-60% “win/loss ratio”,  and focuses on winning more on each win, losing less on each loss.

It’s a difficult thing to predict, because then you’re wedded to your word. It might be easier to work a disciplined entry, position sizing and exit strategy.

The “buy and hold” argument might work for some people, but a trader can’t live on hope alone; the last 20 years will not be the next twenty.If you can’t trade like this, you should buy and hold anything that is diversified (like a mutual fund, an ETF on an index, or an NPS account).

Note: I’ve written about this earlier, and I know I’ve read this somewhere, I just can’t remember where. It’s not original.

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