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Trading
Random trades lead to random results
Jeff Cartridge - March 27, 2008
 Will Kraa commented in a recent article that short term market movements are random. This comment led me to investigate the truth behind this statement and what it means for traders. Is market movement truly random or are there underlying trends that can be identified?
To do this I examined the All Ordinaries market index, the XAO for which I have 26 years of data. I looked at movement over one day, one week, one month and then one year to find any patterns that may exist and found some clear results.
|
Daily Gain |
Max Gain |
Max Fall |
Gain % |
|
0.03% |
5.9% |
-33.3% |
52% |
When we consider just one days movement of the XAO market index the average return is just 0.03%, with the market higher on 52% of the days. The best day the market has experienced in the last 26 years is 5.9% with the worst day courtesy of the 1987 crash where the market dropped 33.3%. On a daily basis Will’s assertion that the market movement is essentially random is certainly backed up by these figures with a 50/50 chance of the market being higher on any particular day. The average movement on a daily basis is also very small with a slight bias to the upside.
|
Daily Gain |
Max Gain |
Max Fall |
Gain % |
|
0.21% |
26.3% |
-35.3% |
53% |
Now when we extend the timeframe and consider a week’s movement the results improve. Studying the XAO once again, the average return over one week is 0.21%, with the market higher 53% of the time.
This move away from trading daily to trading weekly shows an upward bias, with a slight improvement in reliability and strong improvement in average gain.
While the odds of a win on a weekly basis are still close to random the performance on a weekly basis is certainly non random. The best week for the strategy is a return of 26.3% with a worst week of 35.3%
|
Daily Gain |
Max Gain |
Max Fall |
Gain % |
|
0.63% |
14.2% |
-61.2% |
61% |
As we start to look at months the average return grows to 0.63% with the market higher 61% of the time. A gain % of 61% for the market is definitely not random and the average gain shows a clear upward bias to the market. The best gain for a month is 14.2% while the worst month is a drop of 61.2%, once again courtesy of the 1987 crash. A trading strategy based on buying shares and holding shares for around one month has a much higher probability of success than a short term day trading strategy.
|
Daily Gain |
Max Gain |
Max Fall |
Gain % |
|
8.96% |
49.9% |
-29.4% |
68% |
Now expanding the time horizon out to one year we find that the stock market has returned an average return of 8.9% per annum over the last 26 years. The best year for the market was a gain of 49.9% in 2003 with a worst year of -29.4% in 1990. Now when looking at the annual time frames in the market it becomes obvious that events on this time scale are not random. The market exhibits a strong upward bias and is higher often enough to be truly non random.
In reality many traders are searching for a strategy that is right this often. Buy the index on the 1st trading day of the year and sell it on the last trading day of the year. This simple strategy is profitable 68% of the time which means that in a ten year period it is likely to be right 7 out of 10 years and wrong 3 out of 10 years. For the first time the maximum gain is larger than the maximum fall which builds in a risk management strategy to this trading opportunity. Despite this a drop of 29% could result in a very bad year for your account and some essential risk management rules would be required.
This strategy would suit an investor more than a trader with holding periods of 12 months or more. The non random nature of the market over this time frame explains why it is easier for investors to make money in the markets than traders.
When trading on a shorter timeframe the next easiest approach will be position trading where positions could be held for a few months as long as the market continues to move in your favour. Again the strategy here is to trade long so you can benefit from the non random nature of the markets and their bias to the upside. Risk management becomes an essential part of your trading strategy as the market has experienced larger losses than gains and this would normally be reversed in a successful trading strategy.
As time frames shrink to shorter periods market movements become more random and trading strategies become harder to find. Remember trading successfully is all about improving probabilities for the benefit of the trader.
There are many strategies that can be used to increase your probability of success in the markets by finding a bias in the underlying market. This could be as simple as the 123 strategy published in a previous article which trades the market strength at the beginning of each month. Even though the holding period is only two days the strategy is profitable 72% of the time. This is a dramatic improvement on a purely random movement.
Day trading may appeal to many traders, but pickings can be slim and movements are very close to random, making it extremely hard to design a strategy that can pick a clear direction. The market favours a longer term approach by delivering good returns in this timeframe. Short term traders have to work harder to find an edge or a setup that skews the odds in their favour.
Jeff Cartridge is the author of Supercharge Your Trading with CFDs. For more information go to www.superchargedreturns.com.au. Please note that the views expressed here are those of the author, not of CompareShares. Although all investing has some form of risk, CFD trading strategies are only for experienced traders and risk management strategies must be considered.
More articles from this edition of CompareShares:
Investing: Defensive stocks that analysts are targeting
Trading: Random trades lead to random results
Sectors: Analyst puts buys on two energy stocks
Commodities: Should you worry about higher oil?
Advisor Lounge: Rent out your home without paying tax
Markets: Now central banks are buying investment banks?
Commodities: Opportunities arise from gold price plunge
Whatever your views, you can discuss this article - or any of Jeff's articles - on our message board Your 2 Cents.
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