I had been thinking about risk for one reason or another the other day when I began re-reading, for the umpteenth time, "The MindGame", which begins with a market-as-carnival metaphor. And given that the essence of risk is choice – do or don't do, go or stay, forward or backward, yes or no, in or out – one could easily consider risk to be a matter of whether or not one is willing to pay the price of admission. If one wants to gain admission to the carnival, to ride the roller coaster or the Tilt-A-Whirl or the bumper cars or the Torpedo (that thing that pulls the money out of one's pockets as it turns him round while rotating and spinning him upside down), he must be willing to pay the price of admission, even if only to explore the Fun House or check out the freak show. Otherwise, he can't play. He is confined to watching other people have fun and win the prizes. Of course, he can also see people throwing up, but he's not a weak sister. He can handle it. He knows how to have a good time without letting things get out of hand. He's responsible. He's a grown-up. Two tickets, please. And a Sno-Cone.
As it turns out, this is an exceptionally useful question to ask oneself when hesitating over that Transmit button: am I willing to pay the price of admission? But it's a deceptively easy question as much more than willingness is involved in coming up with an answer. If willingness were all there was to it, then sure, why not? But paying the price of admission has consequences that are not always desirable (remember the throwing up?).
Justin Mamis, in his seminal work The Nature of Risk, delineates not one but several types of risk – information risk, price risk, time risk, and ego risk, for starters – and delves into how they all interact in order to aid the trader in deciding whether he wants to pay the price of admission or not. For now, let's focus on information risk and price risk.
The inescapable quandary that every trader faces is that the more he wants to know, the more sure he wants to be, the more he's going to have to pay for it, that is, the more information he has about the success of his trade, the higher the price will be by the time he acts. If he wants to pay less, then he's going to have to give up some of that surety. Maybe a lot of it. He's going to have to be satisfied with knowing less. Perhaps much less. This quandary makes a great many traders extremely uncomfortable, so much so that they find themselves unable to take the trade at all.
The market – that is, those who have the money to move it – always anticipates: good news, bad news, the contents of reports, the outcome of events. And because those in power are always the first to know, the more you know, given your place in the food chain, the later it is; the later it is, the greater the price risk, that is, the more you'll have to pay. Ergo, Mamis states, "all information has a negative bias against the price trend" (which is why John Magee didn't read the newspaper until it was yellow).
Nonetheless, we always want to know more; we always want one more piece of information. But even if somehow all pertinent information became available to everybody all at the same time, price would continue to move due to the fact that the players change, moment to moment, each with his own agenda, all moving price through different prisms. Therefore the question becomes not what information do we need to take the risk, but as this is all the information we have at the moment, how do we use it so as to reduce risk?
It is the nature of the market that one has to act before he knows enough. There is no one moment in which one knows enough to make a risk-free decision. Reducing risk begins with taking a risk before we know enough to make it safe. Reducing risk requires anticipating because the market itself is anticipatory. A willingness to act on that anticipation is what puts us in or takes us out of a trade at a better price.
The value of technical analysis (that is, the analysis of price movement) is that it reduces risk due to its being relatively objective (relatively as compared to fundamental analysis). What one "thinks" about what he sees is irrelevant – either price makes a higher high or it doesn't, either what he sees jibes with the tactics detailed in his trading plan or it doesn't, either support has been broken or it hasn't. Thorough testing enables the trader to come up with a set of metrics, or statistics. These results enable the trader to determine the probabilities of success if he does this or that under a given set of circumstances. Even so, the probability of success of a particular move is never 100%. Which puts us back at the point of deciding whether one wants to pay the price of admission or not.
Even if the trader has and trades only one setup, the character of that setup will vary according to the context in which it makes its appearance. Sometimes everything will fall into place "by the book" and one needn't even think about taking the trade. On other occasions, however, not everything falls into place so easily, and the trader must exercise his judgement, again having to decide whether he wants to pay the price of admission or not.
Back in the day, Disneyland sold books of tickets to its rides rather than a general admission which entitled everyone to ride whatever he wanted whenever he wanted as many times as he wanted. These books contained tickets labeled "A" through "E" (if you've ever heard the expression "E ticket", now you know what it refers to). The "E" tickets were for the most popular rides, the most exciting, the most "dangerous" (for Disneyland). The Matterhorn was an "E" ticket ride. "A" tickets were reserved for the carousel, the rotating teacups, the Storybook Canal. Stretching this carnival/amusement park metaphor a bit further, one can also classify various price phenomena according to how "exciting" or "dangerous" they are. Reversals after climactic moves might be considered "E" tickets, while retracements after breakouts might be more toward the "A" end of the spectrum. Perhaps the trader might be better able to decide if he wants to pay the price of admission if he first identifies whether the potential trade he's looking at is an "E" ticket trade or an "A" ticket trade. Or maybe even a "C". He can then decide whether or not he wants to pay and, if so, how much.
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Don't overlook the 42-55 upper limit "zone" for that daily trading range we were in since April. So any trades in the 48-49 area are going to be difficult. And have been. A good real-life application of "the price of admission".
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When we become quite familiar with stock charts we shall find ourselves looking for various pictures and patterns formed by our charts, but if we are to be complete masters of our study and get the fullest benefits from our own analysis, it is important that we do not entirely lose sight of the fundamental basis for the formation of those pictures and patterns.
That fundamental basis is in actual stock market trading, and actual stock market trading is the result of individual actions by many thousands of people, based in turn upon their own hopes, fears, anticipations, knowledge or lack of knowledge, necessities and plans. It is the danger of losing sight of this human element in stock charts that we must guard against, and since this human element is basic it may be wise to fit it into the foundations of our study at the very outset.
--Richard W. Schabacker
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There may be some confusion over what is or is not a "successful trade". If there is, I'd like to attempt to clear it up.
Whether or not one makes money from a trade has nothing to do with whether or not the trade is successful. The trade is successful if it is implemented according to one's plan. If one pulls out of the trade for some reason that has nothing to do with the market, i.e., if the withdrawal is egocentric rather than marketcentric, that's the trader's personal problem, not a problem with the market.
For example, the circled trade is a successful trade even though the trader may have exited a trade entered at "1" due to its pulling back so far behind his entry price. It is technically successful because it never violated the DP. An entry at "2" would also have been legitimate, but would he have taken it? Probably not. If he had had the equanimity to take "2", he would not likely have exited an entry at "1".
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Last edited by DbPhoenix; July 31st, 2015 at 06:17 AM.
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As I was once a baker, I think of it in terms of cakes. Some will bake their cakes using a mix out of a box. Others will bake their cakes "from scratch" but according to a recipe.
But though there appear to be a near-infinite variety of cakes, all cakes within certain categories (e.g., "yellow") follow the same formula: flour 100%, sugar a percentage of that, eggs another percentage of that, ditto with a liquid of some sort, leavening, and so on. The baker who's reached this level has the formula in his head. All he needs is a list of ingredients. If he follows the formula, his plan, his cake will be a success. If he doesn't, or he makes a mistake (which is where brownies allegedly came from), his cake fails.
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DB, I've known you for over a decade, but this is the first time, I've heard of you being a baker in the past. Incidentally, I'm just getting into baking (especially, pastries), as a side hobby. Now, that I've stolen some of your trading knowledge, I'd love to steal some of your baking tips, and secrets, as well. Would you mind starting a thread about baking, somewhere??
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