Wednesday, December 26, 2007

The Psychology of Trading Part I

Now that Christmas is behind us I want to talk about trading psychology a little bit. I think for the new investor this is especially beneficial because most people have a completely different perspective on what the market is all about.

I will just lay this out piece by piece from my very own brain (disclaimer: reading beyond this point may expose you to abnormal doses of Blain-esque thought process - any excessive harm or good as a result of these readings is the sole responsibility of the person with the currently roving eye).

The first thing I want to do is simplify the entire picture.

1) The stock market is just what it says it is: a Market. defines this as: A meeting of people for the purpose of selling and buying, and a body of existing or potential buyers for specific goods or services.

What? That's it? Where are the Fibonacci signals, the Volume-Weighted Moving Averages, the Price-to-Earnings ratios? That has nothing to do with a market.... or does it?

Well, in a word, no. It does not, per-say. However, those are things that I will discuss as I move along in my blog. But first I want to paint a little picture for you.

When you think of the stock market, what you should be concentrating on is not the word stock, but the word market. See, a market is a medium, meeting place, a point of conjunction. It joins together all of the individuals and companies that wish to purchase something. In this case that thing is stocks, or individual shares in publicly traded corporations.

If you look at what a market was 2000 years ago, things haven't really changed much. Except that now we can visit the market from home instead of loading up a mule and bringing our sack of money or bartering goods. This is very handy, because today anybody can buy and sell stocks from the comfort of their home computer.

Now in a traditional market one would look for such items they would like to purchase - just as we research stocks today. When they found such an item they would offer to buy the item at a price the buyer chose. The seller would either accept or counter-offer. If you were the only person standing around that seller's table making an offer to buy, you had a good chance of getting the price you asked (within reason of course). But what if there were 10 other men and women trying to buy only 5 of those items? Well soon it would become a bidding war! You would offer $10.00, then someone else would offer $11.00 and so on.

Some of the people with you would leave (you might too) when the price went beyond what they were willing to pay. But if that price was continuously offered, it would stay there. You would either have to move on to another product you liked, or wait for all of the buyers to have what they wanted so the price would come back down.

One of the hardest things to define is the word price. We go to retailers and they tell us the price of an item on their shelf. We don't offer to buy for what we think we should anymore, we simply pay the asking price. But folks, the thing about price is that it is what the last person who bought the item for was Willing To Pay for it. This principal is the ruling factor in the market system, where bids and offers are what makes up a stock's price - the last value a block of shares was traded at.

So in order to be a successful trader of any kind - day-trader, swing trader, long term, or anything else - we must first change the way we think about buying and selling. You have more power in the stock market because of the market principal, but you must also be careful because your opponents have more power as well.

Always remember this: In the stock market, your gain is somebody else's loss. If you purchased a stock at $20.00 the person who buys it from you for $25.00 has sacrificed the $5.00/share that you have made to obtain that stock. You have made money on their sacrifice.

But I digress: Back to the market analogy.

There are 3 directions a stock can go: Up, Down, or Sideways. You can make money any which way, but more if it is moving up or down. We are not trading in a market of 50 people or 500 people, folks. We are trading in a market of Millions of people and Billions of dollars.

A market is a group of people, therefore it is dominated by group psychology. I have used the term "panic-selling" previously and that is a big part of group psychology. Reactions based on fear or remorse and most of all - "because everybody else is doing it". When a group of people get together something called "group-think" comes into play. defines group-think as "the lack of individual creativity, or of a sense of personal responsibility, that is... ...characteristic of group interaction."

The basic premise of group-think is that the primal instincts take over and the individual intelligence of group members decreases. A simple example is that in a mob-lynching, probably only one or two members of that mob could EVER do something so appalling on their own, yet the whole group of 30 or 40 plays an active role. Groups tend to think in yes/no terms - or in the context of the stock market - Bear/Bull (up/down) terms.

This plays magnificently to the advantage of someone who realizes what is occurring.

Picture this: A bear and a bull playing tug-of-war. They are facing back to back and trying to run away from each other. Between them is a deep ravine.

These two are ALWAYS at war with each other, trying to run away from falling to their death. Sometimes the bull will see a red flag waving in front of its nose (a surprisingly robust 3rd quarter or a buy-out offer). It will get an extra burst of adrenaline and drag the bear close to the edge.

But the bear is scared to die. After a while enough is enough. An undershot sales figure in a primary department coupled with an executive scandal give its claws an extra grip in the hard earth and it tears a few steps further from doom, dragging that fighting bull with it.

And so the fight goes. Back and forth. Very rarely does the bear ever drag the bull off the ravine (when a company goes out of business or is de-listed), though on those occasions you can smell the fear even from our distant vantage point.

If you refer to my last post "Buying for the New Year", you can see a perfect example of a panic-sell on the E*Trade chart, where the stock has lost over 83% of its value in the last 12 months.

Another Analogy

Another example of the way the stock market works is by picturing an ocean. Literally, in terms of you and me, this is how big the market is. We are one person paddling a canoe. There are cigar boats and other canoes and even cruise ships around us. Sure, when a cruise ship passes by we can feel waves rocking our boat back and forth, threatening to overturn us - but how much of an effect does that cruise have on the whole ocean?

You are a canoeist. A very experience trader or prop-firm is driving a cigar boat, which is fast and can maneuver. Institutions like banks and mutual funds are large ships. Their transactions can affect the movement of an individual stock and rock us, but individually don't affect the whole market.

All of the people boating around in your area are trading the same stock as you are. The price is fairly steady with little fluctuation. But all of a sudden everyone's radio buzzes with the announcement that a terrible storm is coming and it is not safe to be in this part of the water.

What will everyone do? They will pull up anchor and flee, waiting until the storm blows over. But on the next bright sunny day they will rush out to sea in their boats.

So what should you do? When there is the announcement of a storm - be excited! A good trader watches the storm carefully as people run from it and leave valuables behind, and as soon as things look like they are leveling out we jump out into the open and collect the spoils of our patience while other people slowly start to return.

To close this post I will leave you with a quote from Warren Buffet, who is the second-richest man in the world because of trading stocks, that sums up Part I of The Psychology of Trading:

"be fearful when others are greedy and [be] greedy only when others are fearful"

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