From the December 01, 2011 issue of Futures Magazine • Subscribe!

The law of large numbers and avoiding the Siren’s song

Bottom line protection

Could this have been avoided? One way would have been to use a stop at an earlier level. Unfortunately, that would guarantee a loss and also eliminate those trades where the market does perform as expected on the next group of contracts added. It almost assuredly would reduce the overall profitability of the method, making things even worse. Because the method is flawed because the underlying assumption is flawed, any tinkering with the method still will include the baseless underlying assumption.

A different form of protection is required. The assumptions must be changed. Recall the basis was that the market would bounce because all of the momentum was in the direction of the trade. If only someone had the wisdom to ask: What happens if the market is changing direction?

As we know, the market does that periodically and market tops and bottoms are not taken into account by Martin. His method requires a circuit breaker device to detect a fundamental direction change in the market and either eliminate the trade entirely or prevent the horrific loss from accruing.

Research has shown when popular momentum indicators fall outside of 3.25 standard deviations, the markets are ripe for sudden whipsaw reversals. Had Martin incorporated such a filter, he might avoid the losers. For example, on that particular day, the %k stochastic (a common indicator available in essentially all charting software) would have stood under 15 when Martin executed the first trade.

Or, perhaps certain times of the day are better for his system’s performance than others. The trade initiated after 2:30 p.m. Chicago time, and the market rallied from 1085.50 to 1119.50 in the next 25 minutes, eventually closing the bar at 1118.00, having started at a low of 1075.00 in the 2:15 p.m. bar. Research of prior failures could help determine a suitable filter.

It isn’t enough merely to have a money management system if the underlying concept is flawed. Nor is it enough to have a great trading method without money management and a method of confirming each trade or protecting against the impossible event. Both are essential for the successful trader, as is a price-level definition of being wrong. Every system will be wrong many times. Accept that and work to improve it, but never risk all your capital — or even more than is prudent — on any one set-up.

Neil flew home that night, $5,000 poorer but a whole lot wiser. The moral is that the law of large numbers is always there. Beware any trading method that sings so sweetly, but does not take into account impossible events. As the White Queen said in Wonderland, "Sometimes I’ve believed as many as six impossible things before breakfast."

NOTE: This is a true story. The names involved have been changed and the price levels and markets may not be precise, but the events happened and the money lost is real.

Arthur Field has a Ph.D. from Clemson and is a former fund manager for Fidelity International. He wrote "The Magic 8: The Only 8 Indicators You Need to Make Millions in the Markets," available at www.themagic8.com. Email him at themagiceight@hotmail.com.

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