A reader asks: Why do day traders think they know the future?
To which my reply is simple: they don’t.
I should elaborate. Successful, profitable day traders, do not imagine for a moment that they know the future. Perhaps some of the unsuccessful ones believe they possess powers of clairvoyance like 90’s British celebrity fortune teller Mystic Meg. If so, that might explain why they are not making any money.
Snark aside, I understand the point of view of the person asking the question. To see profitable trades in hindsight, such as those posted on this very blog, it probably looks like the trader knew in advance how the market was going to move. It’s easy to imagine that we could fortell with great accuracy how the chart would play out. But to do so is to misunderstand how day trading works.
The job of a trader is not to predict with 100% accuracy where a price is headed. It is not to know the future. Our job is to weigh up the current price, where the price has been recently, and to consider other facts that may influence it. It is to combine all of that information with our knowledge of how prices commonly behave, and to come up with an opinion about where the price might go next. Not a predication, not even a forecast, just an opinion. So our job is not to know the future, it is to know the past and present and to use that knowledge to form an educated guess about the future.
Just like any other opinion or guess, sometimes we will take a strong view and other times we will be less sure of ourselves. For example, we might read a very positive news report about a company, then watch its stock price begin to skyrocket when the market opens. From that combined information we may form an opinion that for the next few minutes at least, the price is likely to rise further. If we hold our opinion strongly — perhaps we reckon there is a better than 50% chance of our guess being right — we might decide to buy some stock. Once in our long position (i.e. holding the stock), we would continue to re-evaluate the price and all other available information and update our opinion about what the price might do next. When our best guess is that the rise is over, we would sell our position and take our profit.
But what if our best guess was wrong? What if we bought into the stock and the price dropped? The answer, of course, is that we would sell back our position quickly to minimise our losses.
All this constant guessing might sound exhausting, but the thing is that most of the time we won’t be able to guess at all. Most of the time when we are looking at a chart we will have absolutely no idea where the price might go next. And that’s perfectly valid, because most of the time prices wander around in a relatively tight range and there’s no trade to take. We are looking for those “ah-ha!” moments when everything comes together — when we see a pattern we recognise, when the conditions are just right, when we think to ourselves I’ve seen this happen before, and there’s a pretty good chance it’s going to play out like it usually does. We’re not predicting the future, we don’t know what’s going to happen next, but we have a strong enough opinion about it that it’s worth risking some money to profit from it.
If we can form an opinion about short-term price movements that is correct more often than it is wrong, then in theory we are laughing all the way to the bank. And actually, we can be be wrong more often than we are right and still make excellent profits. But that’s the subject for another post!