On Market Timing

By: Guy Lerner | Mon, Nov 9, 2009
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Everyone tries to time the market to some degree. Just the acts of buying and selling are exercises in market timing. We want the best price, and I don't know anyone who can argue with that. We all want to buy low and sell high, and we all want to do it over and over again. The problem is that, like hitting a baseball, market timing is not a feat that can be done by everybody, and even the best must accept that they won't be successful most of the time.

Over a lifetime, being a 300 hitter will get you into the hall of fame. It is being consistently good over a period of time that counts. In trading, depending upon your style, it is being good over a period of time that will make the difference. There is no way you will get it right all the time.

But think about that for a moment. Getting a hit 3 out of 10 times you step up to bat will earn you immortality. 3 out of 10 seems mediocre, but in baseball it is greatness. In trading, fortunately we can do better, but like in baseball, perfection is not required.

So what do I mean by style? If you are a long term trend follower, most would agree that a 40 to 50% hit rate is good; in other words, you are going to lose more than 50% of the time. But if you do it right, the profit factor, which is the ratio of gross profit to gross loss, should be relatively high. It could be as high as 10 to 1. If done right, you will have a lot of little losers and several big winners.

Another style is to have a lot of winning trades. Let's say you want to get 70 to 80% of your trades right all the time. This implies that your profit factor will be more like 1 to 1. So for every dollar you risk, you expect to make one dollar in profit, and you expect to do that 70 to 80% of the time.

Your style is your choice. Do you want to be a singles hitter or a home run hitter? Both have their appeal and advantages and disadvantages. You style is what is comfortable for you. Whatever you choose to do, just choose to do it consistently.

But that is the rub as the problem most people have with market timing is that it is very difficult to execute in a disciplined fashion. It isn't that timing the market is hard to do; it is that most people cannot do it in a disciplined, consistent fashion.

So why is that?

I believe the difficulties that investors have with market timing is that they don't have a plan. They are unable to articulate when they will buy and sell. They are unable to articulate what they will buy and sell. They are unable to articulate how much they will buy and sell.

In my opinion, the best way to develop a plan is through the back testing process. Make an observation about market behavior and design a study to see if that observation would have made money. But there is more to the back testing process than finding a strategy that is profitable. This is just the first step. The back testing process can tell you if the strategy is acceptable to you or not. For example, a strategy may be profitable but you may have to go through a 40% draw down or loss to your capital to achieve that market beating performance. Now ask yourself this question: can you execute a profitable strategy that has a draw down of 40%?

By putting a strategy through the back testing process, it creates the expectation of how that strategy might perform going forward. Of course, the past does not always predict the future, but if we don't know how things worked in the past, we will never know how they work in the future. We should not expect the past to predict the future. The past should only be a guide that will allow us to function in the future.

Let's take another example from the medical field. I have performed over 10,000 epidural injections in the last 20 years. The possibility that I will encounter difficulty with the next injection is very possible. The likelihood that I wouldn't be able to solve that problem -because I have seen almost everything- is low. This comes through experience, and the back testing process is a way of creating that historical perspective.

The back testing process and the development of an investing plan provide another very important key to successful trading and investing. You need to have an objective way of measuring how you are functioning in the markets. How else do you know if your plan is working if you don't have a way to measure it's effectiveness? A disciplined approach provides that framework for benchmarking future returns and losses.

So let's stop and summarize. Market timing is just finding the best times to buy and sell. It doesn't mean you will get everyone right. Back testing improves the market timing process of buying low and selling high by creating future expectations of performance and by creating a framework from which we can benchmark future performance. Going forward, this creates discipline as it provides the necessary tools to function in the markets, which can be a very hostile environment.

Two other considerations are noteworthy.

First, you should know what you are buying and why. This is rule #5 of my "11 Rules For Better Trading":

"Understand your market edge. My edge is my ability to use my computer to define the price action. I level the playing field by trading markets and not companies."

Second, have a money management strategy. That is, know how much you want to buy and why. A sound money management strategy will keep losses acceptable and allow profits to run. It sounds simple and you have heard those words a thousand times, but it is really true. There are few things you can control in the markets, but money management is one of them. This is rule #6.

In short, I know what I am going to buy and sell and I know why I am going to buy and sell. If I get it wrong, which does happen, I have my money management strategy to back me up.

I hope this analysis provides you with some insight as to why I think a market timing is useful approach. We all do it. I just want to do it better!



Guy Lerner

Author: Guy Lerner

Guy M. Lerner

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