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Fooled by Randomness

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Posted by Tyler Bollhorn - StockScores

on Tuesday, 08 August 2017 07:42

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In this week's issue:

 

  • Weekly Commentary
  • Strategy of the Week
  • Stocks That Meet The Featured Strategy

In This Week's Issue:

- Stockscores at the Toronto Money Show
- Stockscores' Market Minutes Video - Do You Know Who is Winning?
- Stockscores Trader Training - Fooled by Randomness
- Stock Features of the Week - Stockscores Simple Weekly
-
Stockscores at the Toronto Money Show
I will be doing two presentations at the Toronto Money Show in September, one free and the other a Master Class that you can purchase a discounted ticket to until August 17th. For more information on these two presentations, click here.

Stockscores Market Minutes - Do You Know Who's Winning?
Traders need to know what is working best now and that is often not answered best by the performance of the market indexes. This week, I look at the importance of knowing who is winning in the market, my regular market analysis and the trade of the week on TEVA. Click Here to Watch
To get instant updates when I upload a new video, subscribe to the Stockscores YouTube Channel

Trader Training - Fooled by Randomness
We have all heard the story about the King who asks a group of blind men to feel an elephant and report back on what an elephant is. Each feels a different part and as a result, each has a very different perception of what the elephant is. They fail to accurately understand the Elephant because each does not touch the entire animal.

 

Many traders fall in to a similar mistake when evaluating their approach to the market. It is very easy to misjudge the effectiveness of trading rules by looking at the result of the last trade. If you buy a stock because it is breaking to new highs and the trade ends up failing, it is easy to say that buying stocks breaking to new highs is not an effective strategy.

This concept is referred to by some as being fooled by randomness. By drawing conclusions from a small sample of data, the trader makes an incorrect assessment of cause and effect.

To really judge the effectiveness of strategy rules requires they be tested over a large sample size, at least 30 trades but more is better. Only then can you start to see patterns and correlations. Only then can you assess cause and effect.

Suppose you are sitting in front of your computer and you decide that you will buy shares in Herbalife (HLF) if the next car that drives past your window is blue. The next car that drives by is blue so you buy HLF and the trade ends up making you a $1000 profit.

Encouraged by your result, you take a look at Pfizer (PFE) and again determine that you will buy the stock if the next car that drives past your window is blue. The next car surprises you by being blue so you buy and again, you make a profit. Trading seems easy!

What do you think would happen if you carried out this rule for your next 30 trades? Since most will realize that there can be no cause and effect between a blue car and a winning trade, most will say that the overall result should not be positive. Intuitively, you know what there can be no correlation between the color of the car that drives past your window and the performance of your trades.

However, what if your test actually finds that 25 out of the 30 trades you do end up being winners? Is there now reason to believe that blue cars predict strong stocks?

The problem is that even when there seems to be a correlation between one factor and a result, it could simply be that there is another cause at work. The reason that there was 25 winners out of 30 could simply be due to a strong trending market that makes most stocks rise.

This example highlights two important considerations when assessing the effectiveness of strategy rules.

First, make sure you test a rule over a large sample to get data that is reliable.

Second, test your strategy rules over varying market conditions so you can remove bias.

When testing the rules of a strategy, do not stop at the entry rules. Evaluate the exit strategy and how you size positions and do risk management. Small changes in any of these areas can have dramatic effect on your profitability. I recently completed a two week test of one of my day trading strategies and found that a couple of minor changes to the exit strategy more than doubled the profitability of the strategy during the test period.

If you want to truly understand how well your trading strategy works, take the time to compile data on a large number of trades across varying market conditions. Avoid looking at just one factor or the results of your last trade.

Ran the Stockscores Simple Weekly Market Scans for the US and Canada, checking out the 3 year weekly charts for opportunities with a focus on stocks under $20. Here are some that have good potential for Position trades:

1. GLUU
GLUU breaking up from a rising bottom on good but not great volume. Support at $2.65, 7/10.

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2. CSTM
CSTM making a cup and handle break with strong volume support. The breakout signal is valid so long as support at $8.


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References

 

  • Get the Stockscore on any of over 20,000 North American stocks.
  • Background on the theories used by Stockscores.
  • Strategies that can help you find new opportunities.
  • Scan the market using extensive filter criteria.
  • Build a portfolio of stocks and view a slide show of their charts.
  • See which sectors are leading the market, and their components.

    Disclaimer
    This is not an investment advisory, and should not be used to make investment decisions. Information in Stockscores Perspectives is often opinionated and should be considered for information purposes only. No stock exchange anywhere has approved or disapproved of the information contained herein. There is no express or implied solicitation to buy or sell securities. The writers and editors of Perspectives may have positions in the stocks discussed above and may trade in the stocks mentioned. Don't consider buying or selling any stock without conducting your own due diligence.

 


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