It is quite common to hear someone say "This stock has got to go up!" or "This stock has got to go down!" In such cases, the trader has made a prediction that the stock should move a certain way based on research or analysis and is ignoring the facts about what the stock's price is saying right now.
Certain strategies require that a price movement is faded (where a position is accumulated as the price moves against the trader), but for most individual traders who have small positions, there is little need to fade the market predicting that it will reverse at any moment. Traders, especially short-term traders, are far better off actually waiting for price to confirm a reversal. Some ways of reworking our thinking to help us in this will be looked at in the second section. The first section looks at reasons why predicting can be a problem. (See also: Forecasting Market Direction With Put/Call Ratios.)
Why Predicting Is a Problem
- The future is uncertain. No matter how good our analysis is, it is only as good as the information that is available right now. We cannot know for certain what will happen tomorrow. Analysis in regards to likely movement in the future is done with the idea of "all else being equal." This means that we assume a stock will go up based on a trend if things remain as they are right now.
- We can't predict all contingencies. While on some days, in fact many days, everything does remain equal, there are always days, weeks, months or even years that defy the odds. It is during these times that predicting can be especially dangerous if we are wrong in the prediction. Predicting that something will go up when prices are falling can cripple a trader's finances, especially since we can't know for sure how the market will react to further news or information that may become available. When prices are falling, even good news may not push prices substantially higher, and when prices are rising, even bad news won't necessarily have a long-term negative effect on price.
- If the overall market moves higher, this does not mean a stock will also move higher. Often, analysis for individual securities is based on the sentiment of the overall market. This can mean a trader expects one stock to rise because the market is rising, or vice versa. This does not always occur, especially in shorter time frames. Unfortunately, an alternative scenario also occurs where a trader expects one stock to outperform while the rest of the market continues to fall. Traders must be aware of market dynamics as well as individual stock dynamics. Either way, the end result is that we want to be trading in the direction of current cash flows, not against them, whether it be in the overall market or individual securities. (For more, see: Financial Wisdom From Three Wise Men.)
- Predicting that a particular stock should move higher is vague, and the investment decision will rarely include a profit or stop-loss exit point. While not always the case, inexperienced traders predict that their equity positions will rise and assume that they will be able to get out near the top if they are correct. In reality, such a vague plan will rarely work out. Therefore, all traders must have a plan for how they will enter and exit a trade, whether the trade results in a profit or a loss.
- The holding time for stocks has decreased along with increasing volatility. Stock market volatility has increased over the years, while the holding period for securities has fallen off. Buying and holding is still a viable strategy if the method is well devised (as with any trading method), but due to limited capital, buy-and-hold investors must be aware that volatility can reach very high levels and must be prepared to wait out such periods. Active traders trading on shorter time frames should trade in the direction of price movements given that volatility has increased and even short-term moves can sustain overbought or oversold levels for extended periods of time.
- Statistically, prices rarely move in straight lines for long. Predictions are often based on strong emotional feelings – the stronger the feeling, the stronger the trader may expect the price reaction to be. Thus, the trader assumes that the stock will fly in the anticipated direction in a straight movement, leading to a homerun trade. When we look at all the securities in the world and then factor in time variables, having a position right before a major move is very unlikely, statistically speaking. Traders are far better off trading the averages and trading in the direction of price movements to gain profits as opposed to looking for one trade or stock that rises aggressively in their favor in a short period of time. (See also: Riding the Momentum Investing Wave.)
Alternatives to Prediction
Given that we now understand trying to predict a turning point in the market can be very costly, one asks "If I can't predict, how do I make money?"
The answer is that we follow the price, and we can do so by following the guidelines below. This is not an exhaustive list of market dynamics, but understanding these should help traders find themselves more on the right side of the trade than on the wrong side.
- Prices fluctuate in waves. Looking at any chart after understanding the points above, all traders must understand that prices move in waves on all time frames. This means that, even though prices may fall, traders don't need to panic and jump out of positions as long as the longer trend is still up. However, they still should have an exit point in case prices are no longer in an upward trend on their time frame. Short-term traders can participate in each of these waves but must remain nimble and not be tied to one direction when doing so. To predict that prices will move in only one direction is to disregard the factual tenet that prices move in waves. (For more, see: Exit Strategies: A Key Look.)
- Don't assume support or resistance will hold. A very common misconception is that support and resistance will hold, or that a break of these levels will cause a substantial breakout. The position traders have often determines what they predict will occur. What traders need to realize is that support and resistance levels are simply important price areas. Making assumptions that a breakout will occur or that a level will hold off a further move is an attempt to predict the market. Rather, traders should watch what occurs around these levels and then enter as momentum moves in one direction or the other. If resistance holds and prices retreat, then a short position could be entered, for example. If a breakout occurs, then a trade in that direction can be taken. Keep in mind that false breakouts occur, and – again – prices move in waves. Don't be tied to a position simply because a position showed a profit for a time.
It is better to think of support and resistance as pivot points for price and thus areas to look for entries and exits. By doing so, we are not predicting that something will occur or going against the prevailing price movement. Instead, we enter into the current price flow. This makes trading "matter of fact" as opposed to emotional. We have picked out important levels that will help us isolate the price waves a market is moving in. Then we can take a corresponding position as prices react at these levels. (See also: Support and Resistance Basics.)
The Bottom Line
The problem with knowledge accumulation is that often it makes us more ardent in our views and opinions, and so we make bolder predictions. Predictions can be very costly, especially when we take positions against the prevailing price movement in anticipation of a quick and sharp reversal. Several reasons have been laid out for why predicting the markets is dangerous and ultimately not needed in order to make money. By realizing that prices move in waves and that we should not predict whether important levels will hold or be broken, we can enter trades at significant points but in reaction to what price is actually doing and not what we expect it to do. Traders benefit by remaining nimble in their positions and not being tied to a particular direction because of a prediction. (For additional reading, check out: The Psychology of Support and Resistance Zones.)