Tom gave a reply that I think deserves more attention. Tom made the following comment to one of my blog entries.
One more thing, if the market is random per the stochastic process and you can’t find patterns in a market where patterns don’t exist, then why do we have trends? A trend is a pattern in my opinion.
If you look at the definition of stochastic process at wikipedia it does not say random as in completely random walk. What the definition is saying is that at each and every point multiple realities can occur.
The way I learned it, and it is the way I will explain it, is to look at a stock chart without hindsight bias. The example I want to illustrate is MOT for the past 2 years. Look at the following chart and tell me which way MOT is going? I am pinpointing the situation where MOT rallied slightly and is having a pullback day.
Is the above diagram of MOT going to go up or down?
Answer is down with some up!
Again with the above picture in mind where is the stock going?
Answer is a rally, but where is the stock going after that?
Answer MOT is dropping like a rock.
In each of the situations the technical analysis were behaving similarily, yet the outcomes were different. This is a stochastic process in that the outcome reality is not known. You might be able to assess a probability, but it will not mean that the outcome with the highest probabilty is the reality. Probability is just that, a bet that it may or may not happen.
Ok, so back to Tom’s comment, why is that there are trends? Because sometimes a reality is a trend. If you are quick enough you can latch onto the trend and ride it. From what I have read and heard about trend trading is that you wait for a trend to evolve and jump on it.
Traders who subscribe to a trend following strategy do not aim to forecast or predict markets or price levels; they simply jump on the trend and ride it.
If you have traders that jump on a trend then that trend will be amplified and the reality of the stochastic process is a trend. The trend will stop when people stop riding the trend, and then people will start jumping off, causing the price to fall. I think what many forget is that trend traders DO NOT PREDICT the market.
I think to build a trading system you need to think reaction time, not prediction. Chart patterns, etc try to predict the market and you jump into the market when you think a prediction comes true. It is like playing chess where you think of a strategy and think of the moves your opponent is going to make. Whereas trend trading and stochastics is about reaction time and being a goalie in ice hockey. A player might come at you from a specific corner and shoot the puck, but a goalie never assumes that a player will carry out a certain strategy. A goalie is prepared for all situations based on past actions. The two are similar, but yet in the execution are very different. I suppose this is why a chess player thinks all day about strategies, and a goalie has a puck shot at them all day long.