The Scientific Approach to Trading (by Retracement Levels)

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This post has no trading setups in it, just a couple of thoughts on the way we approach the market problem.

There are many methods widely available to the public, from Elliott Waves, to Technical Analyisis, Indicators, etc. to try to figure out what the market will do next.

One thing that seems evident is that the vast majority of people is looking pretty much at the same things, although very few take the time needed to question these things. Do they really work or not? Are they based on scientific logic or delusional fantasies? Etc?

I'd like to make some example of the folks that make long terms predictions, for example stating that Gold and Silver will go up a lot in the next few years, or that the SPX will collapse and go back to 300, or that US bonds are the short trade of the century, etc.

The common mistake that I see in all these arguments is the complete lack of scientificity. The reasoning behind them is weak.

In my view, when someone argues that Gold and Silver will go up for the next 10 years, because of this and that fundamental reason, it does not matter what the fundamental reason is, these people are basically making a wild guess and the outcome is 50-50 at best.

The problem is that guessing is not a scientific method.

Most people will argue: well, we do what we can, because no one really knows for sure what the market may do tomorrow, so we try to guess.

I surely agree, no-one knows what the market will do tomorrow. And we should stick to that.

Those that bought at the 2009 bottom were lucky. Those that shorted the market top in 2007 were lucky as well. But if you ask them, they will tell you proudly that they were smart and they will explain you how they did it.

Maybe a few were actually smart: maybe they had a method that actually guessed correctly the possibility to have a long trend change, but luck remains the key confirmation point of any bet.

In a way we could say that a successful investor is someone that has made a guess and that guess turned out to be right (luck). However, only the really smart investor will make many right guesses in life, while all the other investors will have a few lucky shots here and there and then will fail in all the other cases.

If we want to be long-term successful with our investments, we do not have to make long-term investments.

We simply need to stop guessing.

When we approach the markets every day, there is only one way to increase constantly our chances of success: we must use a scientific approach and treat the market as a scientific/mathematical problem.

If we fail to do that, we are inevitably doomed in the long term because we will be subject to the roulette of outcomes generated by our (unscientific) guesses.

The problem with the mathematical/scientific approach is that it has a high entry barrier: maths are complicated and most people has very basic mathematical skills (many cannot even sum up double digits amounts without the help of an electronic calculator).

Obviously scientists are a minority in this world, ignorance is dominant in most fields.

That is why most people fails at trading.

Trading is not different from creating an engine for a car, or building a bridge, or coding a complex software. No-one sane in his mind will ever start any of these enterprises without some solid preliminary scientific studies of the problems that will need to be tackled.

Interestingly, most people start trading thinking that no science is required. The gambling mentality prevails. Wild guesses bases on non-logic reasoning are the rule.

The outcome of this type of business is poor, I think we all know that well.

All this said, please forgive me if I want to close with a… guess. Probably in 200 years from now, our descendants will look back at the traders and investors of this period and say:

"What were they thinking?".