Monday, April 9, 2007
What do your photocamera, frying pan and stochastic have in common?
Have you ever heard "What a wonderful photo, you must have a great camera!"? Does it make much sense to you? If yes, you are not alone; for some reason it sounds reasonable. Let's try this: "What a wonderful food, you must have a great pan!" I bet this doesn't make sense at all, does it? Quite obviously, the pan is merely a tool which at best may limit or broaden the possibilities of tool user. It may not be as obvious in case with camera, simply because modern camera is extremely sophisticated gear enabling average user to take quite spectacular shots. Let's, however, set the simple experiment: Give primitive $150 Point&Shoot to a professional photographer and give state-of-art $3000 digital SLR to an amateur. Send them in the field for 1 day. Ask each to bring 100 photos. Compare the results.What's the point of all this? Well, both the photocamera and the pan, however different the level of sophistication may be, are just tools. They don't do the job themselves. They are as good as the person using them is. It's a nut behind the wheel, as usual. For now, remember this important distinction that higher level of sophistication makes it somewhat harder to see this point clearly.
Soooo... what does it all have to do with Stochastic? First of all, let me say it's not about this particular indicator. It's about Technical Analisys in general. Just how often have you heard and maybe said "TA doesn't work!" Or "MACD doesn't work" (insert any other technical indicator or study known to human)? Or, how often have you read yet another heated argument whether they work or not? Here is the deal: unless your computer is broken, they always work! As in, they do what they are intended to do. And this is where major misunderstanding lies: many think that TA is intended to bring profits. Wrong. Indicator is intended to indicate. Something. Anything.. As long as it indicates, it works. Yeah, but why doesn't it bring profits? For the same reason that the camera doesn't take photos by itself even so as long as shutter clicks it works. And for the same reason that the pan doesn't cook a dinner even though as long as it heats up it works. It is designed to provide you with certain tool - and that it does. How you utilize the tool is what defines success or failure. Returning to particular example of stochastic: it indicated the reading below 20%, did it work? Sure, it indicated what it was designed to indicate. Now, what do YOU do with it? Do you enter long for bounce? Do you wait to see whether the price doesn't bounce so you short for downtrend continuation? Do you add another indicator to get some combined reading? Rephrasing it all, it's about how you incorporate certain TA in YOUR trading approach. If you do it right, profits come. If not - this is your approach that doesn't work, not the TA. Or, you incorporated that particular indicator in a wrong way and some tweaking is in order.This all seems to be trivial when you go through this methodology of thinking and comparison; so why is it not that obvious from the get-go? Well, remember the thing about sophistication? In exactly the same way as it seems to be not so obvious in case with camera vs. case with pan, many of technical indicators and studies are being percieved as quite complicated (and they often are). Something so smart must be doing some serious work and lead to solid results... can I relax while it's working and harvest when it's done?Understanding of real purpose of TA is quite crucial for working out the right trading approach. It also leads us to interesting and somewhat controversial topic of trading systems. That, however, is a topic for another post. For now, let's agree: