Let me tell you a little story. When I was first learning how to trade, I would read
everything I would get my hands on about trading and investing. I’m talking from like 70
year old obscure books about the markets all the way to the modern "dummies" type trash.
I’d even read the Financial Times from cover to cover religiously every single day and
I am talking about the actual broadsheet newspaper not the website and magazines like Investor
Chronicle which are often so far behind the news that they are not even worth the paper
that they are written on. With all of that reading and the huge amount of chart time
that I was getting in, I really started to understand the tools that I was learning and
really started to identify the patterns and characteristics in the market.
I had a relatively conservative investment portfolio that was far outperforming the market
I had a risky part of the portfolio that had doubled my money a few times and my active
trading had just started to take off. I tell you what, I thought that I was the absolute
business and we all know that that’s going to end badly don’t we.
With anyone that is learning to trade that starts to accrue like huge amounts of chart
time you start getting instincts of what is going to happen in the market. You build your
experience and you get a real gut feel of what the market’s going to do even without
having to do the actual analysis on the charts. And this is what happened with me, like I
could look at the charts as a snapshot and get a good feeling of whether a trend is going
to continue or reverse and also at the start of the day I had a pretty good idea of where
the day was going to finish in terms of how the candles looked. So yeah I started to get
a little bit lazy and complacent. Like I would see the market falling heavily on one day
on the bigger picture it was in a strong uptrend and I’d think to myself this has got to
run out of steam sooner or later the momentum and can’t carry on like this and so I would
just jump into a trade like a long trade against that trend, and sometimes it would just keep
going against me so the bigger picture it was an upwards trend and the smaller picture
it was a downwards trend that I didn’t think was right. I’d already entered it was going
against me, so I enter again and really arrogantly I’d be sitting there laughing to myself
like: “Ha, the market’s just given me an even better entry” and I wouldn’t be
worried for one minute. But guys let’s put this into perspective
for a second. Right, imagine that you are in a Casino for the evening and you’re having
a good time, you pick up your drink, you wander over to a Roulette table and as you stand
there you see it land on black after black after black after black. Fifteen times the
Roulette ball lands on black. So at that stage if you were going to bet on what was going
to happen next would you think it is going to be red or black? And if you just said green
zero give yourself a slap around the head for being a smart arse. Green zero doesn’t
exist in this scenario. Now this situation did actually happen in
1913 in the Monte Carlo Casino in Monaco, so all of these gamblers around this table
saw this streak of it landing on black every single time and incorrectly assumed that this
streak was causing some sort of imbalance in the odds of the game and therefore a red
was due anytime soon. Now these gamblers actually bet on red appearing next and next and next
and lost millions of Francs at that one table because in fact the streak continued and it
landed on black twenty-six times in a row. Despite this streak of it landing on black,
the truth is that the odds remain exactly the same so after fifteen spins when I said
to you: “Would you expect it to land on red or black?” The answer is that the odds
are exactly equal. This situation led to the term ‘The Monte Carlo Fallacy’. This is
the incorrect belief that just because something happened more often in a set period of time,
it is therefore going to happen less often in the future regardless of the exact odds-
it’s an incorrect belief. Now I’m not going to go through the psychological
reasons for this happening but if you do have time to read about it it’s really really
interesting instead in this video I want to apply this concept or this fallacy to our
trading. Now the immediate quick win we can get from
this when applying it to our trading is to say that we should never ever use a strategy
like Martingale for our position sizing. I see a lot of people use this particularly
for Binary Options which is stupid already, but to keep doubling up your position or whatever
to make sure that you get back to what you’ve lost that’s stupid because it’s always
with the assumption that you can’t lose forever but as we’ve seen even on the Roulette
table where the odds are equal red or black, you can get twenty-six times in a row and
that would be a huge amount of money if you are using a Martingale strategy.
Let’s go back to my trading story. Remember I said that I would double my position when
the market was going in the wrong direction and I would be really smug and happy about
it thinking: “Ha, the market’s just gifted me a better entry point there” and I tried
to double into the trade and I’d be happy about it because I was sure that the market
was going to bounce back and go in the direction that I’d expected it to.
Well many times the market would just keep going and going and going against me until
BOOM! Wiped-Out. You see this all of the time when markets
are trending really strongly and traders are sitting there saying to themselves saying
“well this must be due a correction soon” because of this incorrect belief that what
goes up must come down and visa-versa but do a bit of research. Go onto Google and tell
me how many private investors and even professional traders like fund managers actually went bust
because for over a decade they were trying to short Japanese Government Bonds. That trade
seemed so appealing for a really long time and it sucked people in and it was actually
nicknamed ‘The Widowmaker’ because everyone that got sucked into it at that time thinking
it was a clear short opportunity just went bust, they got wiped out.
Now we don’t want to fall into that situation, we don’t want to fall into this Monte Carlo
Fallacy because that we assume that just because we’ve had ten down days we are due to have
an up day and jump into a trade based on that. This is why all of those years ago I learned
my lesson and I stopped trading based on a hunch. Even when it is really tempting I won’t
go down that route again. Instead I developed rules about trading only when I see failure
at the level. I mean sure I might look at a strong trend and say that has been going
on for too long and the market is severely overbought or oversold at this point in time
but I’m not going to just jump into a trade based on that assumption or that opinion that
I have of the market. I’ve lost way too many sleepless nights over that including
one of the last times that I did that about five years ago when for a three week period
my girlfriend at the time thought I was having a love affair with the Euro. That’s absolutely
true as well, it was a love hate relationship. Instead I have my levels set out from my technical
analysis which you would have seen me do on a broad scale from my technical analysis videos
on Sundays. But I’m not just going to trade these levels as soon as they are touched,
no, no, no. Especially not during a strong trend that is like market suicide. I see this
all of the time, traders trading support and resistance for example as soon as the market
reaches that price level rather than there being any sign of a struggle there. As soon
as it touches it boom in a trade. I mean you have just got to think about it logically.
Would you rather enter here and the price moves through your entry before finally reversing
back up and you have lost that much for reversal? Or would you rather wait until there are signs
that the reversal has already happened and you have maybe lost the initial start of the
reversal, but at least not had to wait for the market to come back to your initial entry
point. You at least know that you are actually riding the reversal. I know which I’d rather
have because the other one triggers stop losses way too much.
So I’m looking for signs that the market is slowing down at my significant levels and
not just that but I want to see signs that there’s failure taking place. So for that
I use my typical failure setups which is a Type 1 or a Type 2 setup and sometimes a type
three setup. If you’ve been watching this channel for a while you will know all about
those. If you’re not sure then just join our Inner Circle mailing list, it’s free
and you will get access to our four part video mini-series where we talk through all of the
basics and that is one of the basics that we cover in that video mini-series. So get
on that now, link is in the description box. In addition to that though I am also looking
for a structural change in the markets. This is particularly on the lower timeframes and
the timeframe that I am looking at for my main timeframe. I’m seeing on the smaller
timeframes, are there changes taking place in the structure? Are the lower highs turning
into higher highs? Are the lower lows turning into higher lows? Am I seeing a reversal taking
place in the structure on the smaller timeframes that’s really showing that there is a struggle
taking place and a change in momentum and the tides are changing that can translate
onto the higher timeframes that I am actually trading myself? You know also is there a change
in the volume or tick data at that point? Are the candles becoming more ‘wicky’
that’s showing like those moments of momentum change? And on top of that if you want to
be on the extra safe side- Has there actually been a candle going in the right direction
for a reversal against the trend? You know that that’s a clear sign that something
has happened in the momentum and there’s a shift in the direction of where the market’s
going it might not continue, but if you have got other factors on your side as well, that
is a very clear indication that something is taking place there.
Like putting all of this into perspective right now with the US equity markets I think
that they are hugely overbought and they’ve only been propped up as far as they’ve come
because of market expansion. I think that there is going to be a big correction at some
point but right now I’m not going to jump in with a short trade on those indices. Like
it would just be suicide like I said I’m going to wait for there to be a clear sign
that the structure is changing in the market and that the tides are turning that might
mean that I lose some massive down days as a result of that but it also means I’m not
going to have those sleepless nights again and potentially having my stop-losses triggered
along the way. I want to look for clear signs that there’s failure. That it’s failing
to reach new highs in the market and that it is not going to go any further. That it
is peaked out and then I’m going to find that nice downtrend and enjoy one of the biggest
trades of my year, which will probably come next year- I’m looking forward to that one.
So basically, I don’t want to dally for the Monte Carlo Fallacy and be the idiot that
stands there and thinks we’ve had fifteen blacks it has got to be red now and twenty-six
spins later realising that you’re broke. I want to be the guy that is waiting for the
odds to really change in my favour and to know for certain that I am actually backing
a good trade at that point in time. You know we want to wait for there to be failure in
the markets before we enter and avoid having that failure in our bank accounts.
Alright guys thanks a lot for watching. I do hope that you are going to keep this concept
in mind with your trading now and make sure that you do things logically and don’t jump
into things all willy-nilly. If you like this video please give us a thumbs up, we really
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will see you very soon bye-bye.