How Markets Really Work

I've mentioned through my previous posts that you should experiment with different ideas. Unless you've purchased a system that actually works fantastically, you'll probably find yourself tinkering with it anyway. And unfortunately that kind of tinkering is along the lines of "well, if I had of used this new rule I've just made up, it would have prevented the loss I just took".

Sure, that new rule may well have prevented the loss you just took, but you have no idea how well that rule works over a longer period of time. You only know how well the rule worked for that last trade, and anything will work once. That new rule may just as well turn your slightly profitable system into a big loser over the longer term.

The moral of the story is to backtest. And backtest properly, which is the topic of a future story :-)

The other reason you should experiment, is because not all the truths you've read about the market are actually true. Or maybe they were true once, back when technical analysts drew charts by hand and there weren't many of them around (technical analysts, that is).

For example, when the price closes above a short-term high (e.g. the high of the last 5 or 10 days), a lot of books say this is a buy signal. Breakout systems are based on this principle.

Another example is when the price closes higher for two or more consecutive days in a row, a lot of books say this is also a buy signal. I think the candlestick pattern is called the "advancing three soldiers" or something like that.

But, a book I've just read, "How Markets Really Work", says the opposite. In fact, it says you're far better to be buying, or entering long, when the price closes below the short-term low. It also says that you're better off entering long when the price closes lower for two or more consecutive days in a row.

The book takes a look at a bunch of other commonly held beliefs about the market as well, and backs everything up with statistics. If you want some ideas to experiment with, and perhaps want to look at the market in a slightly different way to the crowd, I recommend you get your hands on a copy.

What must be remembered though, is that only the S&P 500 and Nasdaq 100 were looked at, positions were entered based solely on whatever was being tested (close above 5-day high, for example), and closed 1, 2, and 7 days later. As I said before, this book will give you ideas to run with, and not trading systems in their own right.