Before you go do a spell check, yes that’s the way I’m spelling the word wisdom. The point now becomes obvious how “so- called” conventional thinking when it comes to the financial markets (or anything in life for that matter) is long on convention, and short on wisdom. Conventional wisdom is quite often associated with an idea that is repeated over and over until it becomes a common belief. In most cases, these ideas are propagated with little evidence to support their truthfulness.
Most of you probably know that before Christopher Columbus set sail for the East Indies—which later turned out to be the new world —the conventional wisdom of the day was that the world was flat. That notion was obviously debunked when Columbus returned from his maiden voyage safe and sound. As it turned out, he didn’t fall off the face of the earth as many expected.
Conventional wisdom also has most people believing that ostriches stick their heads in the sand when they are under duress, when in fact they don’t do that at all. They actually lay flat with their necks parallel to the ground when they sense danger. I have to admit that I believed this one for a long time until one of my colleagues enlightened me on this myth.
In terms of trading, and all things financial, there is a lot of conventional wisdom that is simply unfounded.
“You can never go broke by taking profits” is one of the ideas of conventional wisdom that get many traders in trouble. Now, if the quote were “you can never go broke if your profits are at least three times as much as your losses” then I would totally agree. Regrettably, most new traders don’t understand that from a purely mathematical standpoint, having a good risk-to-reward ratio simply makes good logical sense. Just do the calculation, take a sample size of thirty trades where the win/loss ratio is 50%, and the risk to reward is 1-to-3. We come up with a net profit of $30. Keep in mind that these profits (if the trader can adhere to these R/R ratios) were gained even though the trader was wrong on half his trades. You can see now, that being right or wrong is not as important as how much is lost when we’re wrong -compared to what the profits are when we make a winning trade.
Newer traders are so eager to make winning trades that they lose sight of the math involved in successfully speculating. Lots of small profits followed by a big loser make no sense mathematically, and yet this happens to traders quite often . If this is happening to you, then I don’t need to tell you that your account balance is just treading water. Perhaps one solution might be to learn how to be a better statistician.
Finally, the conventional wisdom on Wall Street is that nobody can time the market and thus it should never be attempted. The solution is just to hold for the long term as the averages will always go up. This also supports the notion that the short-term fluctuations in the market are random. First off, we know that timing the market can be done if there is an understanding of how supply and demand levels are formed in the market. As we show plenty of example trades where we are selling near the highs and buying near the lows in many of the markets that we trade.
The chart below shows a recent trade I took in the Canadian Dollar Futures where I went long 10 ticks from the recent low.
So I guess with the proper knowledge, a sound strategy and execution, conventional wisdom can be foiled. All told, conventional wisdom is what is thought to be true, until the truth is finally revealed.
Until next time, I hope everyone has a great week.