Question of the Week: 4/25/2007
Could you briefly explain what is meant by “river theory”?
This question was sent in by David Lai - a great customer in New South Wales, Australia. Since I have been incorporating Neely River technology in my NEoWave Trading updates for nearly 2 years, it's time I explain this revolutionary concept.
If you have subscribed to the NEoWave Trading service for a long-time, you've noticed my trading style has transformed the last 2 years. For the first 20 years of my career, all NEoWave (and old WaveWatch) services focused on "predicting" markets using wave theory. Because of the detail I attempted to achieve with my forecasts, the process might consume as much as 12 hours of my then 15-20 hour work day. If structure was clear, the second step of the process involved designing a trading strategy that took into account all possible preferred and alternate scenarios. If a position was warranted and activated, the third step involved managing that trade using stop-loss orders and profit objectives based on my presumptions of wave structure and the outlook which it implied. While on rare occasions that approach worked spectacularly well (such as the 2000 - 20002 period in the S&P), it left much to be desired at least 50% of the time.
After pursuing the universally accepted 3-step process (Forecasting, Entering, Managing) for nearly 20 years, 7 years ago I began to question its validity. Why? Even though my forecasting abilities over the prior 20 years had improved several orders of magnitude, improvements in my trading were only incremental. That perplexed me for two decades and was extremely frustrating. How could my forecasting improve so much and my trading so little...what was I missing?
It eventually dawned on me that each step of the traditional 3-pronged process (Forecasting, Entering, Managing) was plagued with problems. First, even if you are good at forecasting, you probably won't be right more than about 50% of the time. Next, even if you are right about the direction of the market, your entry price may be too high or too low, preventing the trade or reducing future profit potential. Even if your entry was great, your stop placement may be too close or your exit too early. If you give each step of this process a 50% rate of success (probably too high), by the time you reach the end you will achieve (at best) a 12.5% success rate. Is there any wonder trading is so difficult for most?
From the first book I ever read on trading ("The Commodities Futures Game") to every financial magazine since, along with every newscast I have ever watched or commentator I have ever heard on TV, the foundation of all those presentations stems from one belief - FORECASTING is the key to successful trading.
Like virtually every one, for 20 years, I believed the myth. Right after the 2000 stock market high, I knew (based on wave structure) the S&P was entering a 15-20+ year consolidation. Based on NEoWave concepts in Mastering Elliott Wave, I knew this meant wave structure would become extremely complex and difficult to interpret for possibly the next 20 years. Not a great environment for trading IF your foundation is a forecasting paradigm.
With that knowledge in hand, in 2000 I began searching for a non-forecasting approach to trading and investing based on the same logical and objective approach that has made NEoWave famous. After 7 years of research, training, trading and programming, a highly evolved "trading science" has emerged, which I call NEELY RIVER THEORY.
In essence, Neely River theory compares the seemingly random action of traders in a market to that of the behavior of fish in a river. No mathematical formula can tell us exactly where a specific fish will be in a river at any one time, BUT there are things you can predict about the general behavior of all fish in the river.
1. Fish do not determine the flow of the river.
2. Independent of personal action, tracking the movement of all fish will show the net result is they move down stream over time.
3. The majority of fish remain within the channel created by the north and south banks of the river.
4. Fish will move the fastest when swimming downstream and in the middle of the river.
5. Near the perimeter of the river, fish get caught in turbulence and whirlpools that will effect their orientation and hinder their progress to the ocean.
6. Fish do not need to make forecasts about the flow of the river or the distance to the ocean to eventually reach that target.
In the same way, you can say the following about traders.
1. Traders do not determine the flow of a larger-degree trend.
2. Independent of personal action, tracking the movement of all traders will show the net result (prices) move "down stream" (i.e., in sync with the larger trend).
3. Trading activity is "confined" by north and south channels imposed by a larger time frame.
4. Traders will make the most money the fastest in the middle of a channel when in sync with the larger trend.
5. Near the perimeter of a market's channel, traders get caught in turbulence that effects their orientation (i.e., it produces uncertainty about future direction) and hinders their progress (i.e., their ability to produce consistent profits).
6. Traders do not need to make forecasts about the trend of a market or the distance to a future target to eventually achieve profits.
Using the river analogy as a guide, over the last 7 years I've developed logical, objective trading strategies that allow traders to reach their goal of profitable trading without attempting to forecast the direction or extent of a market's move.
Though the above statements will no doubt be considered controversial and debated by many, I expect the foundation and technology of Neely River theory will create a revolution in the field of trading and investing.
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