Is Prediction Really Futile?

In my article “Is The Trend Your Friend?” I suggested that trend-following traders think that it is impossible to predict the onset of a new trend, so it’s better to follow the trend once it’s started. Well, that’s what Michael Covel says in his book on “Trend Following”. He also says that you can’t trade the news, because the news follows the price rather than the other way around, and I agree with him.

In my experience, you usually see a massive price fall and then read about about why it happened afterwards. Someone always seems to get there first when bad news is announced last thing at night or first thing in the morning. Actually, it amuses me that important announcements are usually made out-of-hours, ostensibly to create a level playing field by allowing everyone to digest the information. In reality, of course, it means that the market makers and other professionals can position themselves so as to benefit before we mere mortals even get a look in.

By the time you read the bad news, it’s usually too late to benefit from it, except by knowing that you can now buy the stock in question for a much cheaper price than yesterdays purchasers; or by knowing that you had the foresight to guarantee the stop order on your overweight position just in case the worst should happen .You couldn’t predict that the worst would happen, but you new that it could happen, and you knew that the impact would be too big to bear. In terms of risk management, we may not be able to predict the probability of an event but we should be able to predict its potential impact.

While we can’t predict what will happen, we can anticipate the fact that anything can happen, and therefore we can insure the risks we can’t afford to take. We can also react when it has happened… perhaps by buying the stock that today is 20% cheaper than it was yesterday.

Is prediction really futile?

Anyone who engages with the markets must think that prediction is not totally futile, because they are implicitly predicting that the stocks they buy will go up and the commodities they “sell short” will go down (or vice versa). How futile those predictions turn out to be is probably dependent on your trading timescale:

Day Traders think that they can predict the short-term price behaviour based on the recent price behaviour, rather like how I can predict the weather in the next five minutes based on the weather right now.

Position Traders and value investors think that they can predict the longer-term price behaviour based on some fundamental science, rather like how climatologists can tell us that the Earth will be 2 degrees warmer within the next 50 years.

Swing Traders think that they can predict the cyclic nature of price changes, rather like how the seasons cycle through spring, summer, autumn and winter during the year.

The question is: can we predict financial prices any better than we can predict the weather?

Tony Loton is a private trader, and author of the book “Stop Orders” published by Harriman House.