Holy Grail? Foolproof indicator? Highly Accurate Algorithm?

Very often, I am proposed with some special system, an algorithm, a foolproof indicator or a formula that guarantee you to win in the market.  The offers can come from a small quick money making outfits but also some respectable analyst and financial institution with real mathematicians and scientists working on the system.

I received the following write up from Jeff Clark on Feb 8^th and thought it is fun to post an excerpt:

“

The Final Piece of the Puzzle

By Jeff Clark 
Tuesday, February 8, 2011 

Everything is in place now.

For the past couple months, I've been harping about the potential for a bearish move in the market. Sentiment indicators, summation indexes, bullish percent indexes… all the technical indicators are warning of a swift and severe correction. The market doesn't care. It just keeps marching higher.

The high-frequency trading desks, the algorithmic computer programs, and the Bernanke printing press have overpowered the technical indicators and – like Atlas propping the world up on his shoulders – kept a persistent bullish bid beneath the market. The new high list keeps growing. Expensive stocks keep getting more expensive.

Every day I warn investors of the potential risks in the market. And every day I start the morning by washing the egg off my face. Why worry about risks when there are such large gains to be made? "It's a new world," the market says. "Either get on board or get out of my way."

So yesterday I sat at my desk, banging my forehead on my keyboard and wondering what else has to happen before the market corrects. What other indicator has to reach a ridiculously extreme level and warn of the impending doom before stocks finally take a breather? This was 9:41 in the morning, Pacific Standard Time (PST).

At 9:42, the phone rang and the final piece of the puzzle fell into place.

"Hi Jeff," the voice said, "It's your mom. Just wanted to get your opinion on the stock market. We're sitting in cash right now, earning 0%. And we're thinking about buying some stocks."

Get out of the market while you can, folks. The "Mother Indicator" has just issued a sell signal.

Mom is the perfect example of a public investor. She doesn't pay much attention to the financial markets. So if she's aware of a trend, or has an inkling to put money somewhere, you can bet the idea has gone mainstream. And she has a near-perfect track record as a contrary indicator.

Signals from the Mother Indicator don't occur often – perhaps just once every two or three years. They are, however, remarkably accurate… And they always seem to occur within days of important turning points. For example, I first acted on this signal in early February 1994. Stocks had been on a terrific run – up 20% in about eight months. The Fed was easing, so interest rates on CDs and money market funds had been falling. Mom was looking to get a bit more bang for her buck. And for the first time since August 1987, she wanted to buy stocks.”

Without fail, most of these systems fail eventually. Perhaps the exception is the prevailing proprietary high frequency (HFT)  trading desks of major financial institutions that trades in nano seconds using powerful computers and high speed linkage to the Exchange. Great successes are reported for these systems. It is estimated that up to 56% % of trades are generated by these High Frequency Trades (HFT).  So, it is very difficult for trader traders to beat these systems.

However, I remain sceptical. I believe any mechanical system will fail over time. The market is an emotional creature. It is difficult to use mechanical logic to reason with emotions.

It is wise to treat the market as totally unpredictable, at least short term. It seems to suffer from some bi-polar personality disorder, which varies from extreme happiness to deep depression.  It can remain irrational longer than you can remain solvent.

Therefore, there are no secret formula or holy grail.

There is no easy path.

Trading is very much a probability game.

I have my fundamentals. I have my technical systems. But at best it gives me slightly more than 50% probability of winning. Although, longer term the fundamentals if done correctly will work in my direction but it could take a long time!

One great example is to look at Wal-Mart. Over the last decade Wal-Mart's earnings almost tripled from $1.25 per share to $3.42, growing at an impressive rate of 11.8 percent a year. This doesn't look like a stagnant, failing company; in fact, it's quite an impressive performance for a company whose sales are approaching half a trillion dollars. However, its stock chart led you to believe otherwise. The PE declined from 45 to 13.7, or about 12.4 percent a year. The stock has not gone anywhere.

Does that mean that the market is totally random? There are number of academics and books write to prove that we cannot time the market. They favour diversification, segment rotation and rebalance of portfolio to make steady gains. It is believed that the market is random and thus no one can beat the market.

Personally, I believe we can beat the market. I had done it for many years. The important thing is to understand the fundamental dynamics, emotions and irrationality. Market always over extended itself because of emotions. While being confident, we maintain with humility a healthy respect for the market.

How do I deal with the uncertainty?

To begin, I acknowledge that I cannot predict the market with certainty. I am rightly only slightly more than 50% of the time.

So risk control is my Holy Grail. I diversify, keep disciplined position size, rebalance once in while, conduct segment rotations and I hedge.

Successful traders hedge their risk.  Primarily, I use options to hedge. It is the third leg of my trading process.  The whole process is like playing chess with the market.  Various adjustments are made in a trade structure until it is closed.

Using options properly has the wonderful effect of taming the volatility giving control over greed and fear. On the other hand, using options for the purpose of leveraging in a directional trade has the opposite effects.

I will not be afraid to buy into breakout or a change of trend as long as I have considered all the downside risks.

This is the system I believe I will beat the market both short and longer term.