What is and is not prediction?

The nature of what ‘prediction’ means came up a couple days ago, in one of my online discussions. The words that caused me to look into this were, “What’s harder to predict? 1 pip movement or 1000 pip movement?” – in the course an exchange of ideas on different methods. This question was partly rhetorical and somewhat argumentative (not that we were having an argument). It came from a seasoned trader who had on several occasions before claimed to predict nothing. The answer to this ‘novice-type’ question is obviously ‘yes’ – if one is engaged in predicting something. It may have been a slip of the tongue or the so-called Freudian slip. It matters not what it was. The important thing is that I think about it.

Most dictionaries say that ‘prediction’ is “To state, tell about, or make known in advance, especially on the basis of special knowledge.” Note carefully that special knowledge is not an absolute requirement, though it is of importance.

Perhaps the most important thing about making a prediction is that it should come through in order to validate the prediction. If it does not, then the prediction was wrong. Prediction is of course important in a wide range of scenarios in everyday life e.g. business planning or even crossing a busy street. However, it’s more important not to predict in financial trading. Such a statement will appear crazy to novices or those who know nothing about this business.

Seasoned traders are not saying, “The markets will go up or down.” Any trader who makes such a prediction is probably a novice more than a seasoned trader.

For a prediction to be of importance or value it must have the following ingredients:

  1. Specificity about what will happen.
  2. A time frame within which event/s predicted should happen.

A prediction that the US30 will crash, is a meaningless and useless prediction simply because everybody knows that there will be a crash at some point. If however someone asserted “The US30 (or the DAX) will crash some time in the next 4 months..”, that would be something of importance. Those interested would wish to find out the foundations of such an assertion.

2016_05_16_the_prediction_equation

Prediction is also closely linked to expectation and value. No reasonable prediction is devoid of an expectation of something happening.

A prediction is not simply a statement of probability that something will happen. People often take expectation and probability together. They may then make assertions but these are not usually very specific as in the ‘specific assertion’ criteria above.

I return to the issue of whether traders are making predictions about where certain markets may go. There are only two directions: up or down – which are of any importance. No one is interested in a flat market as there is no money to be made from such a lack of volatility.

Only recently I compared trend-following with non-trend-following trading scenarios. Prediction was absent from that comparison. From the trend-following system two sub-scenarios emerge:

  1. Early detection of trend development.
  2. Identification of established trends.

Neither of these activities/assessments predict anything.  One would ask the question, “Based on my criteria is there an early indication of a trend developing?” or “Based on my criteria has a trend been established?” If the either of the latter are answered with  binary ‘Yes’ or ‘No’ then certain actions are taken.

If ‘Yes’ to one or both of the above scenarios (see diagram) a trader may use other criteria to decide whether to enter a trade. What is his prediction? Nothing. He makes no assertion about what will happen. He may have an expectation that the trend may go in the direction assessed – but equally he expects the trend to reverse at any time.

Of high importance here is that there is expectation of both directions. This is similar to having an expectation that the Sun may rise in the East or the West tomorrow (without making such an assertion). The big difference with sound trading practice is having strategies to limit loss if the trend moves against favoured/expected direction and maximise gains if the trend moves in the favoured/expected direction. How far the trend will go in a favoured direction, nobody knows. Control is exerted on limiting loss and maximising gains. Control, however, is subject to human psychology – which is the biggest issue in trading.

DISCLAIMER:
The information provided herein is opinion only. Under no circumstances do any statements here represent a recommendation to buy or sell securities or make any kind of investment. You are responsible for your own due diligence. To summarise, we do not provide investment advice, nor do we make any claims or promises that any information here will lead to a profit, loss, or any other result. All materials are for educational purposes only. We are clear in our SYP.

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