There is something that seems almost perverse in the notion that it is possible to make money on the financial markets without predicting future price movements, whether of an individual security or of the market as a whole.
The trading world prizes “high conviction” strategies, whether based on deep research of the “fundamentals” of an asset or on the careful study of previous price charts. Such strategies necessarily involve stock market prediction methods.
How could they not? It is difficult to imagine a trader taking a strong view without that view being based on a forecast of some kind. To the high conviction trader, entering the market without some sort of prediction would be as irrational as motoring from Chicago to New York while professing complete indifference as to whether to drive east or west.
In this world, the algorithm predicting stock prices is the financial equivalent of a satnav.
A scary prospect?
It is quite true that many traders would find the notion of managing without any kind of prediction scary, to say the least. And, as we shall see, some prediction-free strategies do involve a certain amount of analysis, which purists may regard as being dangerously close to forecasting.
It is a sobering thought that someone with no meteorological qualifications would have a better chance of predicting the next day’s weather in the UK (about 75% of the time, tomorrow is the same as today) than would a veteran trader trying to forecast tomorrow’s market movements.
Because we do not know what will happen tomorrow, we construct predictions based on the information we have now. In simple terms, a trader can spend the weekend poring over Friday night’s closing prices in order to plot the likely next movements when trading resumes on Monday.
Or they can spend the same 48 hours analysing last week’s earnings announcements and dividend figures in the hope of unearthing valuable information about the fundamentals of the securities in question.
The blame game
The problem, of course, is that all this information is old, by definition. In a sense, it is dead data. It tells you what happened in the past, and little else.
Intuitively, we know this, hence the tangle that conventional traders get into with moving averages. Accepting that, for example, Friday’s close gives you very limited information about a particular security, the whole week’s closing prices are added up and divided by five to give a clearer picture.
But this gives equal weight to the oldest and the most recent data, so a “weighted” moving average would give least weight to Monday’s close, a little more to Tuesday’s close, and so on.