Market forecasting can seem like a futile exercise. After all, 95% of the time, predicting what will happen next is impossible. But Justice Litle says its the huge opportunities on offer in the other 5% that make investing worthwhile. Here, he explains how traders can draw inspiration from ice-hockey legend Wayne Gretzky…

This from Taipan Daily:

Wayne Gretzky is widely regarded as the greatest ice hockey player of all time.

At first glance this is an odd thing. When you think of hockey players, you normally picture big, burly, broken-nosed guys with hulking frames and lighting-fast reflexes. (Or at least that’s what I picture. But then I’m not Canadian, eh.)

Gretzky, in contrast, was never all that big. At six feet and 185 pounds, he comes up an inch shorter than your humble editor (who also happens to weigh 185).

That’s not a lot of bulk to throw around the ice. So maybe he was super-fast to make up for it? Nope. Gretzky was never all that fast either.

And yet, this average-built Joe was so far ahead of his peers on the ice, they nicknamed him “The Great One” – and not in sarcasm either. Gretzky earned that nickname.

When he retired in 1999, Gretzky held forty regular season records, fifteen playoff records, and half a dozen All-Star records. He also enjoyed the distinction of being the only NHL player to score more than 200 points in a season. And as if one 200-point season weren’t enough, he did it four times.

Gretzky’s Secret

So what was Gretzky’s secret? How did he do it?

It was brains, not brawn. In trying to explain it, observers talk about The Great One’s “puck intelligence” and ability to “read the game.”

Gretzky was so skilled at processing the real-time subtleties of the rink, in other words, that this one area of dominance enabled him to leave all his stronger, faster opponents in the dust.

When asked to explain his edge, Gretzky put it like this: “A good hockey player plays where the puck is. A great hockey player plays where the puck is going to be.”

Which brings us round to today’s topic. Great traders do the same thing in markets that Gretzky did in the hockey rink. They anticipate where the puck (or rather the market) is going to be.

Pockets of Clarity

A lot of people think trying to predict the markets is a mug’s game. They think it’s pretty much impossible to know what’s going to happen next month or next year or what have you.

And you know what? For the most part, I agree with them. When someone tells me they know exactly what’s going to happen way down the road because of chart pattern ABC or market cycle XYZ, I usually just smile.

Nobody knows for certain what’s going to happen. There are just way too many variables, many of them self-reflexive and changing in real time.

Humans aren’t smart enough to predict the turbulence in a glass of water, let alone the ebb and flow of global financial markets.

But this doesn’t mean prediction is impossible 100% of the time. It only makes it impossible, say, 90-95% of the time.

That last 5 to 10% makes a huge, huge difference! (Sort of like saying the market is “totally efficient” versus “mostly efficient.” There is a grand-canyon-sized gap between the two.)

Think of the markets as shrouded in fog (the fog of war, perhaps). Most of the time things are hazy. You’re watching, testing, getting a bead on things… then every once in a while the fog opens up. For just a brief window of time, in regards to a specific scenario or a specific opportunity, you see what is bound to happen. Everything clicks into place, and you know exactly what to do.

I call these little moments “pockets of clarity.” Most of the time, you just watch and wait and observe. But when you get one of these pockets of clarity, that’s when action is called for.

The same principle works in a hockey rink, or on a basketball court. (If you’re an NBA fan, just imagine Larry Bird, whose limitations and gifts were a lot like Gretzky’s.)

When a player like Gretzky is on the ice, he doesn’t always know where the puck is going to be, any more than a great trader always knows what the market is going to do. That would be impossible.

Instead, a Gretzky-caliber player spends most of his time hustling, observing, positioning… so that when that clarity pocket opens up – when that brief window of opportunity reveals itself – that’s when swift action is taken.

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Hustle Required

Here is another Gretzky quote that translates perfectly to the trading world: “The highest compliment that you can pay me is to say that I work hard every day, that I never dog it.”

It’s hard work figuring out where the puck is going to be. It takes countless hours of thought and dedication and practice. It takes real commitment, day in and day out.

In practice, this means different things for different traders. But the common element is that all great traders hustle.

Some (like me) spend a lot of time developing big picture market scenarios… getting a feel for how the major elements could play out… adjusting the top-down view for real-time events. Others (like my friend Zach, aka Cash McDash) take a more bottom-up approach, digging deep into the stories and profiles of individual companies and industries. But the basic process, the hustle, is the same.

And by the way, sharp long-term investors do this too.

A good value investor still hustles and anticipates the puck – just typically more from a balance-sheet perspective, and without worrying so much (or worrying at all) about timing.

If you find an undervalued company with a lot of good things going for it – strong balance sheet, smart management, loads of cash in the bank, quality assets on the books and so on – you can reasonably expect that, with enough patience, something good will happen to the share price at some point in the future.

The key thing, again, is working hard and thinking about where the puck is going to be – specific ways in which the future is likely to shift relative to the present moment.

What most investors and traders do — buying something because the PE ratio looks okay, hopping on a stock because some talking head on CNBC recommended it – is nowhere near the same thing.

Taking Shots

Gretzky said something else that is especially useful for traders: “You miss 100% of the shots you don’t take.”

In practice, this means you don’t have to be right every time. As long as you have good risk management principles in place, it’s okay to be wrong. In fact, great traders often expect to be wrong a fair percentage of the time.

To understand why, let’s go back to the hockey rink again. Imagine if Gretzky only took shots when he was absolutely 100% sure he wouldn’t miss. Would he ever have had a single 200-point season, let alone four of them? No way. Fear of failure would have led to paralysis, or at least cut way, way down on the total number of shots scored.

Great traders know that as long as the risk management is in place, it makes sense to take calculated risks.

You can prove this yourself with a simple math experiment. Imagine you had the chance to bet heads or tails on a fair coin toss – tails you lose $1, but heads you win $2. How many tosses would you sign up for?

I would take an infinite number of tosses at those odds (if anyone were fool enough to give them to me). Even losing half of the time, you come out way ahead… and the more you toss, the further ahead you get.

It’s easy to see this with a piece of scratch paper. Just tally up the wins and losses. After 10 tosses (assuming an equal split of heads and tails), you would be $5 in the black. After 100 tosses, $50 in the black. After 10,000 tosses, $5,000 in the black, and so on.

Keep in mind, too, that a good trading rule of thumb is to look for at least 3-to-1 upside on your trades (rather than just 2-to-1).

That is to say, don’t take a trade unless you think you have a fair and reasonable chance of making triple the amount you’re putting at risk. So if you have, say, $500 in planned risk on a position – the amount you stand to lose if stopped out – you want to have a realistic shot at $1,500 in net profits on the trade.

In fact, with 3-to-1 sizing guidelines and consistent risk management, you could actually be wrong 60% of the time… only getting it right 4 times out of 10… and still make a strong profit!

You can see this again with the math. Imagine a series of ten trades where you win four times (40%) and lose six times (60%). At 3-to-1 reward to risk, you come out six units ahead: (4 x 3 = 12 units of gain) – (6 x 1 = 6 units of loss).

Play Ball

To borrow from one last sport, just think of batting averages in baseball. Ted Williams was a hero for batting .400, which meant one of the best that’s ever played the game failed to connect 60% of the time. (And any multi-millionaire baseball player alive would give his eyeteeth to bat .400 today.)

You don’t ever want to be wrong intentionally, of course. But the best trading opportunities are often the slightly unnerving ones – like the blazing fast-ball screaming in at 90 miles per hour. Will it drop low and left or come right across the plate? If you’re in the game, you can’t be afraid to swing when the timing feels right.

Source: To Be a Great Trader, Think Like Wayne Gretzky