Some say the key to prediction is more / better information. At the same time, can’t too much information be overwhelming?
Statistician, Nate Silver calls this overload of information, the “noise.” He makes the point that in today’s world of big data, the difficult task is to separate out the “signal” from the “noise.” Basically: What information matters? And what information doesn’t?
This overload of information is the case with predicting heart attacks. Writer Malcolm Gladwell tells the story of Cook County Hospital in his bestselling book: Blink: The Power of Thinking Without Thinking.
During a Q&A on this issue, Gladwell had this to say:
One of the stories I tell in Blink is about the Emergency Room doctors at Cook County Hospital in Chicago. That’s the big public hospital in Chicago, and a few years ago they changed the way they diagnosed heart attacks. They instructed their doctors to gather less information on their patients: they encouraged them to zero in on just a few critical pieces of information about patients suffering from chest pain–like blood pressure and the ECG–while ignoring everything else, like the patient’s age and weight and medical history. And what happened? Cook County is now one of the best places in the United States at diagnosing chest pain.
So what do predicting oil prices and predicting heart attacks have in common? Exactly what I have already implied: Maybe more information is not always better.
Is there a simpler way – a way that does not give most of us a headache? Is there something that anyone can easily follow that would give us insight into all of the available information on oil? A variable that allows us to tune out the noise, and focus on what matters?
There is: It’s the price!
Every variable, both known and unknown that are influencing and constantly setting the current, and future, price of oil are captured in the price.
By using the price of oil to forecast the price of oil, a simple prediction rule might be:
If oil prices are moving higher – we predict higher prices.
If oil prices are moving lower – we predict lower prices.
Most traders call this prediction method: “Trend-following.”
Trend-following trading, however, is not really a prediction at all. Like the name says: It’s following.
In this method, you are simply saying: “I have no predictions or ideas or preconceptions about where the market is going. But wherever it goes, I will follow it.”
Just to show the idea, let’s make a few imaginary predictions (post-hoc) using only the price of oil as our indicator.
If the green line (the 15 day moving average of prices) is above the red line (the 30 day moving average of prices), we predict that prices will go higher.
If the green line is below the red line, we predict that prices will go lower.
Over the last year, if you followed a trend-following rule, like the one above, you probably would not be wrong very often – and when you were wrong, you would not be wrong by much.
Fivethirtyeight.com economic writer Ben Casselman asserts that it is basically impossible to predict what the price of oil will do. He is right. Commodity prices are impossible to predict in a systematic way. Commodity prices are, however, easy to follow in a systematic way.
Good-grief, following the signal in the graph (above) would have begun pointing to lower oil prices beginning in July-August of 2014.
Feel free to play with different time frames and a few other commodities to see it for yourself.
But can trend following actually work, you ask?
Trend-following trader, billionaire, and owner of the Boston Red Sox, John Henry had this to say:
I don’t believe that I am the only person who cannot predict future prices. No one consistently can predict anything, especially investors. Prices, not investors, predict the future. Despite this, investors hope or believe that they can predict the future, or someone else can. A lot of them look to you to predict what the next macroeconomic cycle will be. We rely on the fact that other investors are convinced that they can predict the future, and I believe that’s where our profits come from. I believe it’s that simple… when I was designing what turned out to be a trend following system…[that] approach–a mechanical and mathematical system–has not really changed at all. Yet the system continues to be successful today, even though there has been virtually no change to it over the last 18 years.
I’ll take his word for it.
[Note: The connection between trend following trading and the book “Blink,” by Malcolm Gladwell was first introduced to me by author Michael Covel in Episode 44 of his popular podcast, available on iTunes.]
*This is for informational purposes only, and not a recommendation to buy or sell.
There is substantial risk of loss to futures and options trading.
Past performance may not be indicative of future results.
One should carefully consider their financial suitability prior to trading futures or options.
A longer version of this article was originally published under the title: How to Predict the Price of Cotton.