| Here's is where we start to have some fun. | | | | observed them. |
| Regardless of how you want to trade the markets | | | | The best way to demonstrate this is with a game. Let |
| you need an approach. It might be spinning a bottle, | | | | say we are going to make a bet on the toss of a coin. |
| asking your Aunt Jenny what she thinks or just gut | | | | You start with $100. We will toss this coin once per |
| feel. | | | | day. If it comes up heads you win 3% and if it comes |
| However you do it, even though you may not think so, | | | | up tails you lose 2.5%. |
| you have an approach. | | | | At the end of the first day you will either have $103 or |
| The majority of traders will eventually use some form | | | | $97.50. At the end of the second day we repeat the |
| of technical analysis (also known as chart traders, | | | | process. |
| market technicians and chartists). | | | | The probability of the coin landing heads or tails is |
| Just before we go down this road of mystical wonder | | | | exactly 50%. This is because regardless of how many |
| I think it is very important that you hear both side of | | | | times the coin is tossed each event is independent. |
| the argument of why technical analysis works. | | | | The coin has no memory of what happened the toss |
| For every book that there is on making money trading | | | | before. This means that the results will be totally |
| there is probably an opposite book explaining why it | | | | random. |
| can't be done. Before you dismiss the last statement | | | | Kendall's paper implies the same effect in the stock or |
| out of hand. Lets explore the argument that no matter | | | | commodities market. If each day is an independent |
| what you do you can't beat the market. | | | | event then the markets must be random. We shall talk |
| Random Walk | | | | about more probability's later. |
| The random walk theory dictates that a security | | | | Taking this idea slightly farther if the markets are |
| prices changes randomly, with no predictable patterns. | | | | random then the history of the price of a stock or |
| Now that's quite a statement but there are number of | | | | commodity has no bearing on the future price. It |
| very respected statisticians who have a very | | | | wouldn't help to look at charts or data, as each day |
| convincing argument to prove it. | | | | there would be a 50% chance of the market going up |
| It all started in London with a man called Maurice | | | | or down. |
| Kendall who presented a paper to the Royal Statistical | | | | You may be thinking by this stage that this theory is |
| Society in 1953. The subject of the paper Kendall | | | | rubbish. I can trade the markets and make money! Try |
| presented was the behavior of stock and commodity | | | | this simple test. Have a look at the two charts below. |
| prices. | | | | One is a chart of 100 daily closes of the Dow Jones |
| Kendall started out looking for predictable price cycles | | | | Industrial Average and the other is a 100 random coin |
| in stock and commodities prices. The problem was he | | | | tosses. |
| couldn't find any. | | | | Makes you think doesn't it! If each day in the market |
| Regardless of how he approached it, the price of a | | | | were in fact an independent event then it would be |
| stock was just as likely to go up or down on any | | | | impossible for you to make money from it consistently. |
| given day despite what happened on the previous day. | | | | You see any succession of event's particularly |
| Which is where we get the term Random Walk. | | | | independent events can have an aberrant run. This is |
| Prices seemed to follow a random walk as he | | | | what kills the trader. |