There is a famous trading book that ‘proves’ you can enter the market with a random entry and still make money. Or did it prove that? There’s some important lessons to be learnt when we take a deeper look.
The strategy was simple:
1 – Enter the market at random
2 – Use a trailing stop loss to exit the trade
Now, of course, the authors didn’t actually trade the system, they just showed how it would have worked on a number of markets over a 10-year period. In that period, the system made a profit.
So can we stop learning anything else about trading, use these 2 rules and retire to an island somewhere?
Let’s have a think about what this strategy does. First, we enter the market. It doesn’t matter if we go long or short. We have a trailing stop loss order that will follow the market if it moves in the direction of the trade and will sit where it is if the market moves against us.
If the market is trending, then the random entry trades that are against the market will quickly get stopped out. On the other hand, the trailing stop will ensure that the random entry trades that go with the market will ride the trend. So of course, the winners will be larger than the losers. That’s where the profit comes from.
So what’s the problem with random entry?
Well the problem is that this is not a profitable system and it’s not really a completely random system. It’s a trend following system. It makes profit when the market is trending and it loses money when the market isn’t trending. In the book, the back-test showed markets that were predominantly trending.
Don’t agree? There are options strategies that do the same thing. The “Long Straddle” is a strategy where you buy a call and a put option with the same strike price. Effectively you are saying “I know it’s going to move, I just don’t know which way”. It’s not a random entry, it’s a ‘prediction’ that volatility will increase. There’s nothing random about that. The system described in the book is doing the same thing. If the market went into range mode as it did for most of 2016, your random entry system would lose.
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