Numbers

Trading and investing are numbers game. Today I am going to examine two ways I see numbers and their effects on, and relationship to my way of going about this game.

First is the numbers we use to base our assumptions, rationales, and theories on. This group of numbers are generally grouped into the category of “Data”. Second is the numbers we use to attempt to gain an edge and hopefully to profit on a regular basis. This group of numbers fall into the category of “Statistics”.

For the sake of ease of writing this I am going to use the term “trading” where I could use “trading and investing” unless there is a reason to differentiate the two. So when you see “trading” assume I am referring to both unless I say I am not.

In my trading I rely on a very large amount of data provided by numerous sources. Whether it’s the trade price and volume from the exchanges I use to assemble charts to the numbers in the reports from companies in their quarterly or annual reports to the data the government supplies in their economic reports. I spend a lot of time analysing this data so I can determine what my course of action will be and my guess is if you’re reading this, you are as well. The trustworthiness of this data is critical to my being able to make these determinations and I dedicate a fair amount of effort to ensure this is the case.

Lately this data is proving more and more difficult to verify as accurate. In fact, as I’ll attempt to point out here, it has become questionable on many fronts. Data from the exchanges, while still extremely accurate, no longer tells the whole story. Due to the inception of markets outside the exchanges such as dark pools and crossing networks the data from the exchanges is rapidly becoming a smaller percentage of the total picture. Corporate reports are subject to more and more doubt as accounting standards change and regulatory oversight is hamstrung by budget cuts and a larger pool of companies to oversee. And government reports are subject to political forces, changes in methodologies, and unreliability of the data used to compile them. The GDP report from friday (31 July 2009) included revisions to the previous reports going back decades.

http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm

Of particular interest to me was the bevy of headlines touting the “Better than expected” 2nd quarter 2009 GDP numbers. An “advance” of minus 1% was .5% better than analysts expected and this was seen as great news in places like the NY Times. One must note that the previous quarter numbers were adjusted downward by .9%, and if that happens again it would mean the numbers were worse than analysts expected. Previously in this Blog I have urged readers to remember when judging the words of pundits and talking heads, that they must be assumed to be talking their own book until proven otherwise. The same should be assumed when the government provides these reports, albeit to perhaps a lesser degree. The folks who put these reports out are under tremendous pressure to support the position of the powers that be, and combined with the fact that previous reports have been revised almost every time, and almost always in a manner that suggests the original was inaccurate in favor of the position of the powers that be, must make us take pause at the numbers and view them with a skeptical eye.
Worse yet, if we don’t take the time to drill down into the raw numbers, we have to rely on the aforementioned pundits and talking heads to do it for us. This now adds a second order slant to the data, compounding for us the difficulty of good analysis upon which to base our trading decisions.

When I make decisions on where to place my trading capital, and how much of it to place, I am attempting to gain a statistical advantage that results in a consistent profit. I realize going in that nobody wins every time, and in fact it is likely that most active participants in the market lose most of the time. As a believer in the “plan your trade, trade your plan” theory I look to develop a strategy that can be tested to show a consistent profit and to do this I use statistical analysis. Most people who come into this business concentrate on the ability to do Technical or Fundamental analysis, and if you go to the StockTwits recommended list you will find folks whose skill at this is nothing short of amazing. I have found in my professional experience that unless these things are combined with a robust risk management strategy the end outcome is poor. When a technician advises me of a set up he believes is advantageous, before I make a trading decision I want to know just how predictive this set up is. A good example that is easy to visualize are the Gap plays, if a stock gaps up or down at open, what percentage of the time does the gap fill. A beginner will fade the gap, but the pro will know ahead of time, what % of the time this company fills gaps, what % of the time the gap fills in the sector, industry, and broad market, what factors influence the %, and are they present for this trade. The pro will also take note of the times the gap didn’t fill and how much of a move was necessary to tell him the position is not viable. After all that the amount of capital to dedicate to the position is determined, and entry and exit points are determined.

So where are the statistics? The Edge?

My point here is not to teach a statistics course, but to point out that knowledge of statistics, and using them effectively, is a skill that differentiates the average from the excellent. Most people do not really understand statistics, and make conclusions that seem sensible but are actually erroneous and lead to negative outcomes. The closer an event is to statistical certainty (Lowest possible risk) the more money I will put toward the position, that’s risk management. If my inability to understand statistics causes me to underestimate the risk and over capitalize the position I will eventually suffer. If you watch the show Deal or no Deal you will see the average folks inability to grasp statistics resulting in poor outcomes. The banker is giving the contestants the choice of continuing on or taking the amount that statistics tell is the most likely outcome based on the amounts left in the cases and the choices required to be made. Most contestants end up with less than the bankers maximum offer.

To conclude, I would urge the reader to do two things:

1) Maintain a healthy skepticism with regard to the reliability of the numbers presented to you
and
2) Learn to use the numbers in such a fashion as to gain the edge you need to prosper in this business

These things take time and effort, but they don’t call it “the hardest way in the world to make easy money” for nothing.

Good luck and Good trading

aiki14


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