How to Approach Trading in a Non-Deterministic Environment

Folks, I just wanted to post a few weekend thoughts regarding how to use Elliott Wave and perhaps how to even view markets.

First off, my thesis is that future prices in the market are purely uncertain. Meaning our inability to predict them precisely is not due to lack of information or understanding. A coin flip, for example, is only uncertain because we can't measure all the factors in real time to predict the outcome. The market is not like this, in that it's outcomes are not determined at the outset, instead they are probabilistic and TRULY uncertain.

As such there's no crystal ball indicator or combination of indicators that if we get just right, we'll know what's coming next. Our goal is not to "solve" the market. As such we don't make deterministic forecasts, we make probabilistic ones.

As an analyst I don't much care to guess whether or not 3115 would hold yesterday. Like everyone else who asks the analysts "Is 3115 going to hold?????"  I too want to know but recognize that I never will truly know in advance, only in hindsight. 

How to approach trading in a non-deterministic environment.

Step 1 is the toughest: Stop worrying about being right. I don't want to be the goalie fielding a penalty kick (will the 3115 penalty kicker go left or right???) where I must be right to win.

Step 2: A need to nail tops and bottoms in the market is a great game for your ego and a terrible one for your account. I didn't get long at yesterday's lows. As a matter of fact, as a human with an opinion (not in my capacity as an EW analyst) I thought 3115 would break directly and I looked to short the first bounce and I got stopped out for a small loss. After we completed 5 up off of support, we were able to recognize that there was good evidence an important low in place and thus with a clear invalidation level to trade against, I got long on last night's pullback and took profits today near the close. Might the setup off of yesterday's low failed? Absolutely, it could have. But a 1-2 off of support has good edge in my book and so I'll trade it EVERY time. And, I'll do so without worrying, "will this one work out?".....segues into the 3rd..

Step 3: Stop worrying about every trade being profitable. Again, we don't know if a 1-2 setup off of support will hold or invalidate. No one knows...What we do know is that it holds frequently enough considering its overall projections for us to make money by betting on it consistently. From a trading standpoint that's what a probabilistic approach is all about. If you're managing risk and not oversizing your trades it shouldn't really matter if this trade pans out or not. 

Consider a dice. Imagine someone say when 1 or 2 hit will pay you $4 for every $1 you wager, when 3-6 hit you lose the $1, 1-2 you get $4. In this scenario your chances of being right are only 33% and yet you should take this bet every time with the only caveat being that you're not betting too large a portion of your holdings on any individual bet. Your long run expectation is to win $2 every 6 bets you make. Suppose someone presented you with this opportunity. Would you really be concerned about losing some when 3-6 hits?

Many ask what the exactly probabilities are of various scenarios that analysts present. I have no idea to be honest and don't imagine it's even very testable. What we do know is a setup like 5 up / 3 down occurring off of support has a good chance to continue upwards, at least to the 1.0 extension.

What advantages do we have over the dice analogy? We get to limit our risk while the dice is in mid-air so to speak. Using fib pinball we have a great tool to recognize "as the dice is in the air" what is relatively more or less likely to occur. Has price exceeded the .618 extension off a potential wave 2? If so, we can likely move stops up to that wave 2 low. Now we've strongly reduced our risk. Has price exceeded the .764 extension? Now we can move a stop to a little below the .618 and nearly guarantee profit. Has price reached the 1.618? Now we can move our stops up and protect more profit.

Fib pinball provides us with a framework and parameters to make lots of good bets, reduce the risk at points along the way, and both protect and target our profits. 

Jason Appel is a financial markets veteran who hosts our Beginners Circle section for new members and provides coverage of U.S. stocks and cryptocurrencies.