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Concepts & Tutorials

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.

  • Murty says:

    Well said! I am surprised at your energy levels, how come always your thoughts seems to be afresh?
    Of all the satements, I laugh at :””Excercise Caution at these levels” ….Does it mean to Raise? Hold or Sell the quantity?
    It is better to resort to Binary trading, by keeping some money you want to lose! At least you have a self-satisfaction of playing on your own.
    Short term traders can enter at these levels, take long (how long??)positions…… If at all words can kill
    Here is my addition!
    While observing one of the GREAT ANALYST, I found this hillarious(For me at least) one:
    Stock XXXXX
    Present rate: 320
    Recommendation: Buy with a target of 420
    Stop Loss: 220.
    I mean, what kind of prediction it is? It’s not a joke,some one suggested this strategy for a particular stock. I liked the middle one. Poora Chaar Sou Bees!
    Apart from this, of late I was reading somewhere::::was it the article on Buffet?
    * Do not buy a stock, unless you want to hold it ………permanently

    • Thanks mate! And what a lovely example of the 420 🙂

      • Murty says:

        Really,
        Foreacsting techniques ! Mmmmm!
        Let us continue………
        AxisDirect Suggests……
        JPPower Ventures has a peotential upside of 105% From 22 to the 52week high of 45… Sure, the emphasis is on the word “Potential”……
        JKBank target 1549 on 6th june(27% from 1220) and sticks to the same word on 17th June! Meanwhile the stock remains at 1221, going upto 1280 in between. Man, I gave a word and I would stick to it!
        Deepak, which method they follow? The 20 day moving average or 200DMA or Something something? A popular Business daily follows the same ……. Roadside parrots are 100 times better!

        • Murty says:

          Here is another BLOOPER!
          The Circuit limits of a Share were 17.95 and 21.85….
          Now , the Great PG, MT etc suggests the target of 27!
          the Stock is GMR Infra……….

  • lohit says:

    “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). ”
    99% (probably more) of the population in India should heed this advice. And yet most retail investors lose money in the stock market. Most likely because they listen to the constant drivel churned out on our business TV channels.
    The NPS should be advertised more and offered as an alternative to the Provident Fund. This was initially proposed in the first draft of the Direct Tax code, but was quietly killed off due to objections from the EPF org. Competition is apparently still anathema in some parts of the govt.
    The PF is not bad though with the tax deduction. However, I remember reading somewhere that its expense ratio was quite high, I forget the actual number. Do you know ?

    • Yes, NPS can’t replace the EPFO due to political reasons, but it is now compulsory for all government employees that joined after 2004.
      PF is okay, it’s a guaranteed product with no tax on withdrawal and nowadays the rate is around 8%, which, post-tax, is awesome. The good thing about it is that even if the government traps you in a false case, they can’t attach your PF as it’s unattachable. Also, it gives you liquidity after a few years. The expense ratio doesn’t matter for a guaranteed product (it’s 8%, no matter how they earn it)
      The NPS expense ratio is negligible. They’ve been able to give 12%+ returns per annum since 2009, btw.

      • Shashi says:

        The breakup of PF allocation is given below (http://www.chrmglobal.com/Replies/4570/2/PF-Basic-Break-up.html):
        Employee:
        12% of Basic+DA = Provident Fund
        Employer:
        3.67% of Basic+DA = Provident Fund
        8.33% of Basic+DA = Pension Fund
        1.61% of Basic+DA = Admin Charge (PF Admin Charges@1.10%, EDLI Contribution@0.5% and EDLI Admin Charges@0.01%)
        While returns from PF is fine, government pays a pittance as EPS. My father worked in a mid-senior level position in good company and the pension that he receives is close to 1600/-. The annuity is feel is designed to give back minimum and earn. A PSU bank fixed deposit pays a lot more.
        NPS also has annuity component on maturity, which upsets many to go for it.

  • Paul says:

    NPS has an “invisible entry load”. You need to pay 0.25% one time payment to make investments to NPS – this is in a country where you can transfer 1lakh with just Rs.5/-. Now the fund management charge is also 0.25%. Another ripoff!!!

  • Hi Deepak,
    This is an incredibly well written primer on equity trading. The whole discussion of it as a set procedure or almost set of rules is a great start for new traders.
    I was curious, can you write an article on Straddles? I often hear of people trading different options straddles but don’t really understand the mechanics behind how they work.
    Thanks for the article. 🙂

  • Mehul says:

    This is out of context but wonder why so many sms-trading-tips-giving service providers are based out of Indore?

  • Rajat Bose says:

    The day you can predict direction, intensity and time correctly, you will wipe clean the option market.
    The most difficult of the above three is to predict the time and the easiest is perhaps the direction part. Bullish intensity can be gauged reasonablyt well by taking note of the short build-up in the security in question apart and/or the degree of the element of positive surprise in any news event affecting the price movement of the security coupled with what kind of buying happened prior to the event, at least, in the last few sessions. Bearish intensity can be understood through judging the extent of long build-up that would come in for bull liquidation as well as the degree of the element of negative surprise in any news event affecting the price movement of the security coupled with what kind of distribution already happened prior to the event, at least, in the last few sessions.
    So far no concrete tool publicly available to predict the time horizon of a particular move that is acceptable to the modern man schooled in the current paradigm of thought that posits nature as something inert and objectivized while all meaning resides in the human mind. This essentially threw out several subjects like astrology (an ancient tool for time projection), homeopathy and a part of technical analysis that deals with the thoughts of R N Elliott and W D Gann among others irrespective of the fact that they could be pretty effective in dealing with the job. Thus, trying to predict time could be hazardous on both counts as you can go wrong since it is a very difficult to do it correctly and even if you are right you can be accused of resorting to pariah subjects like astrology or something even more esoteric.

  • Rajat Bose says:

    One more point, Deepak. Please read the book: Trade Like Warren Buffet by James Altucher where you will see that this venerable sage of Omaha bought stocks some of which he discarded later as early as nine months down the road.
    Please do not go by the mythic construct that is built around him while one should try and learn many things from him in our investing endeavor in the market that can be applied by you and me, mere mortals, unlike the sage the who can sit on the board of big companies to steer their direction in his favor, whether for good or bad is besides the point.

    • You’re right Rajat – I’ve always said on this blog to not follow what Buffett *says*, but to see what Buffett *does*. He has exited of course, from Salomon to the recent FMCG exits.

      • Murty says:

        If at all I have listened to my Grandpa!
        Deepakji, and Rajatji,
        No one suggests simply follow the *SAYINGS* of Buffet or whatever the Jhunjunwala does, but a small obseration here is that even Buffet was successful only 60 percent of the times. It is the Imitators we are afraid of , and they are everywhere.
        On June 3rd, AXISDIRECT recommended ADANI ENTERPRISES to buy at 221 with a 37% upside. today it is around 190 and the latest call was to SELL by someone, with a target of 170. What events in your statements could have triggered the suggestion or its downfall?
        Even the stocks suggested by one Mitesh, were in DOLDRRUMS: These are said to be great stocks: McnallyBharat, Anantraj Industries, (Lupin, an exception), and Spicejet! You know who owns them or bought them of late!
        It is not advisable to follow someone blindly. EVEN he is a GOD of Sharemarket!
        KNOW YOUR STOCK!

  • lohit says:

    If you have neither the time nor the inclination to put in the effort needed to make money by short term trading, please read – http://www.fool.com/investing/general/2013/06/18/your-last-remaining-edge-on-wall-street.aspx

    • Great points. But in India, you’d have done better with mutual funds in the last twenty years (which is how long they’ve existed).
      It’s also ludicrous to assume long only buy and hold returns for short term traders. Those rules are for short term investments in mutual funds who are long only by definition. Traders will go short as much as they go long, and disciplined traders have made phenomenal amounts of money (from John Arnold to Soros to Chanos to Paulson etc.) This is attractive to a very large set of people, but also those who only want to gamble.
      In the end, I am a trader and would like to encourage those that want to trade to learn the skills and discipline they need, instead of just chasing the next tip 🙂

    • Murty says:

      The word “RETURNS’ is always mis-interpreted.
      First the Trade advisors say short term, and if they fail, they say it is for long term.
      will you be happy with a 12% year on year returns for a period of 7 years and say my MF or Stock has doubled? We are not discussing about Debt markets or Govt. FDs.
      Please correct me if I am wrong!
      In the end whatever statistics you follow, only one thing remains! YOU MAKE MONEY OR NOT!

  • Santosh says:

    My next door neighbor is a rich auto parts trader. Operates quietly and never gives tips. He protects his business from competitors. In trading it seems everyone gives free tips and is willing to train competitors at a price.
    Why do people have the urge to give tips at all? Why do traders invite and train competitors? Why not silently make money & laugh all the way to the bank?
    The reason is that sooner than later tip givers become Tip sellers. (Final Goal of those who dont make money trading in the Stockmarket is Tip selling).
    A simple check of the stats of any broker reveals why. The number of traders who make money consistently in trading is minuscule. The money made by tip sellers & those teaching/organizing training programs for stock traders is far more predictable.
    And of course everyone wants a predictable source of income.
    ucb