80% forecast - let's be humble

What happens if some day there will appear on the market a system that gives 80% accurate forecast?

Let's be humble. Instead of 80%, let's suppose that we finally got a trading system that ALWAYS gives us 65% accurate forecast for the next day. In other words,  this system is able to tell the price direction between Open and Close for the next day, and the accuracy of the forecasting is 65%. It means that for any 100 trading days the system provides 65 correct calls versus 35 incorrect ones.

Suppose that it has happened 10 years ago. Let say that somebody presented this system as a Christmas 2006 gift. Starting from that moment, our Christmas story begins:

After Holidays we decided to spend about $20K on trading. So, in the morning of January 3, 2006, we have bought 200 Apple shares at the cost of $72.38 per share. In other words, we have invested $14476. Our system gives 65% accurate forecast, so we follow these simple rules:

- if the system forecasts UP movement for the next day, we open a long position at the opening of the exchange and close it when the exchange closes;

- if our system shows DOWN, we open a short position in the morning and close this trade at the end of the trading day.

It is two trades per day paying $20 commission ($10 for each trade).

Within 10 years, we always traded the same amount of shares, 200 shares. In other words, we did not reinvest our profit money; instead, we put them to our bank account, far away from that crazy stock market.

In ten years, we would find on our account $634K. It means that we have increased our capital in 42 times during those 10 years!!!  This is screenshot of software that calculates such profit:

WOW!!! I like that. What if we want to make more money?

No problem, we do reinvestment. Let's change our strategy a bit.

Suppose that on January 3, 2006 we have created a special trading account and put there $30K. This is our capital. Everyday we do a trade as in the previous example. The difference is that we spend only half of our capital on buying Apple shares, instead of buying the same fixed amount of Apple shares every day. It means that the first day we spend $14,982.66 to buy 207 Apple shares. Next day we do the same, calculating  the amount of shares to buy according to our current capital and applying this miracle system to our trades.

What will we find on our trading account in 10 years? We will find this:

Within 10 years, we would make almost $4.3M from initial $30K. Average Annual return of this system is 140% per year.

If  your trading system provides 70% forecast in ten years you will find $17M on your account:

The Annual return of this system 187%.

That was a Christmas story. It is over, and now the cold hard reality begins.

The appearance of this kind of a trading system with 65% accuracy is the same as the appearance of a black hole not far from our cozy Solar system. In this situation, sooner or later, everything will disappear in this hole. Though there is some good news - astronomers do not observe any black holes nearby.

There is some good news for the rest of traders as well (for those who do not own 65% forecast system) - "efficient market theory" that states that the stock market is effective. In other words, the stock market does not like when somebody's forecast works too well and takes too much money from the stock market. In this case the stock market changes its behavior, and our super forecast system stops working. And we will listen survivors who keep telling the same story again and again: "some time ago I made a lot of money, and at one moment I lost everything..."

I do not state that this is impossible to reach that return. It looks like fast trading systems do that, but this is another story. As I understand, once in some months these trading robots should be readjusted, and nobody knows when these robots stop bringing a profit.

My friends, let's be humble.

Sergey Tarasov

January  10, 2016

Toronto, Canada