The Psychology of Trading Part II: Technical Analysis - Is It Really That Technical?

Image from theinnermind

Greetings all!

I've had some excellent reviews of my Psychology of Trading Part I and I am very excited to carry forward with this.

My primary goal throughout these posts is to simplify and break down the idea of the stock market. Stockbrokers and Fund Managers WANT this stuff to seem as absolutely complicated as possible because you will be too insecure to invest your own money - inevitably, because we are all told that investments are the #1 way to build a nest-egg, we hand our money to them... because somebody has to do it.

Well many current mutual funds are on par for a significant loss this year and historically the average stockbroker doesn't make their clients any money at all; they don't sell profits to their clients, they sell the idea of profits. Which, unfortunately and for many, are not actualized in any way.

On another side note: I am sorry for the lack of pre-warning as previously promised, but I made a purchase of BIDU (Baidu.com) about 15 minutes before the close. I am a current shareholder of BIDU since last January, where I purchased 100 shares at 118.34. So far the stock has definitely performed well.


Today I picked up another 100 shares on my E*Trade account to ride out the stock. Now this one is not for the weak or heart - firstly because to buy a minimum 100 shares you would need $40,000.00 right now, and secondly because it is very volatile - today's trading range was over 24.00/share in price movement, or $2400.00 of profit/loss at only 100 shares.

Now I got in this 100 shares at just over 400.00 even, and it closed off at 398.87 for a small loss of around $1.50/share (keep in mind that this is only 6% of ONE DAY'S TRADING RANGE)



Ergo, even if I only catch 2 or 3 decent days up I can make $4,000. I am setting my stop at $378.00/share or a potential $2250.00 loss. My gut, based on the strength of the bull (upward) movement the last 6 months as well as the overall success of GOOG (Google's stock up over 700% in the last 3.5 years) which Baidu is basically the Chinese version of (with a 4.5x bigger market!) tells me that my purchase will be well over $500.00/share within the next 2 months.

As usual I apologize for digressing. But I did promise at the start I would post my transactions and the reasons for - the #1 reason to buy BIDU? People are bull-crazy for Google's business model and therefore that translates over to BIDU which is younger and has MORE growth potential. Their loss is my gain.

So what I want to talk about today is stock charts - Not the different types of charts or time intervals or color-coding or anything like that. No, I want to talk about the chart itself. What it is. What it represents. The story it tells and why it plays bard to its publicly traded company.

So what is a stock chart?

Well, before I define the meaning of the chart, I should define what its source of data is, that being the stock ticker, or ticker tape. A ticker is "a computerized device that relays financial information to investors around the world, including the stock symbol, the latest price and the volume on securities as they are traded" INVESTOPEDIA . Basically it is a real time quote of a stock, telling you how many shares are traded, when, and for how much.

Image from Walden Group

I can't find a quotable source on the actual definition of the word chart on its own in relation to stocks, so I will define it myself:

A chart is A visual representation which sums up all of the transactions during a set period of time on a time vs price scale. This in essence sums up all of the information flying through the stock ticker.

So instead of having to sift through 150,000 trades on a single stock to see every transaction for the day, you can refer to the daily chart to see a summation on a single page of every trade for that day. A little easier to manage, wouldn't you say?

Now, why is the chart so significant?

Well if you refer back to The Psychology of Trading Part I you will remember the market principal. And if you remember that, you will also remember that a market is based on buying and selling by a group of people with singular intent, that's it. A share's value is entirely perceived (intangible) by both the buyer and seller. When they can agree on a mutual price a transaction occurs.

So what determines this agreeing point? The truth be told I believe that 90% of trades in the stock market are are based on 1 thing which is comprised of 3 things: Group-think, which I also discuss briefly in Part I, is the factor in 90% of trades. Group-think is instinctual, based on Fear, Greed, Remorse, or a combination of them all.

Most of the "agreements"/trades made between buyer and seller are panic-oriented. Somebody hits their Market-Buy key (a shortcut key when trading stocks that says to purchase a certain number of shares at the lowest offer price instead of making a bid) because they are scared they missed the train. This is one of many many examples.

The stock chart is the storyteller of Group-Think on a particular stock. It tells you whether the Bear or the Bull is winning the tug-of-war over a particular period of time. And let me tell you, once you know how to recognize what is happening, a chart can be as loud and flourishingly blatant as any living-room yarn-spinner.




For Example:





Each chart shows the mentality of the majority of people buying and selling that stock.

In a downtrend, more people feel the stock is of less value and therefore offer less or sell for less. In an uptrend, more people feel the stock is worth more and therefore offer to buy for more or won't sell for less.

You will see uptrends and downtrends on every stock chart you look at. Some only last a few days or weeks, some 6 months, some 40 years.

But the chart tells the story. Say I look at the Up Trend chart and I refer to the peak of the second Bull-Run (the second point from the left). What changed the price of the stock? It could have been any number of things, such as poor macro economic data, an undershot quarter of earnings, a hit in that particular sector because of a new law restricting business. Who knows? I don't need to know any of that, though, because I have drawn a loose trend-line.

When you recognize a trend and want to jump in on it for a short bull-run, where do you think the best point is to do that? As close to the trend-line as you can get. The idea is to get in when selling negativity is still just starting to ebb. What happens to the uneducated amateur (I call them "fish") at this point is something called "buyer's remorse". This is especially effective on higher-volume stocks as more traders are subject to this.

Buyer's remorse in terms of stocks is where someone bought shares and they were up, up and up, but held on because of greed and lost half of their winnings in a down-swing. The result now, is a combination of panic and greed (they want to keep some of what they made) so they sell out. When the stock price goes down lower and lower, the buyer remembers the money they made before. "The stock is cheaper now and I know it will get back up there again" they think. "Just like before. This time I will make my money all of the way!" This time it is greed and remorse again that makes them buy the stock at its cheaper price

What you have to do is to be one step ahead of the fish. They will wallow in doubt and anguish until the group-think pushes the price the other way. Then they will jump on board with the rest. That's where you have a full reversal and the stock starts to move upward again.

The trick is to get on at the trend-line, because there is where the price will start going your way. Also, you have a natural reference point for when you can enter the stock, and you can exit pick your exit by looking at how far up each retraction moves. (i.e. if every time the stock moves up again it goes .15/share higher in price than the last time, you can pick your selling point to match it.)

But what is even better about this is that you can trade with tight stops (how much money you are willing to lose before you will sell). If you look back and see that the last three times the price touched down to the trend-line, the most it went under was by .25 before coming back up, you can put your stop loss in at .35 below the trend-line to account for some slippage and bad news or other small external factors.

You also know that if the price carries on through your stop-out it has probably reversed the trend completely and now you can watch for short-selling opportunities in the future.

The trend-line's slope tells you the power of the ruling mentality. In other words, the sharper either up or down a stock's price moves, a higher % of traders on that stock feel it is worth more or less as the trend warrants.

A comparison:



Which is the sharper uptrend? Chart # 2 has a much sharper slope and therefore the bull-mentality has much more power here.

Chart # 1 has a very slow uptrend with wide movements, telling you that mentality shifts more strongly and over a longer term with the bulls coming out only a little ahead in the end.

Which is the better long-term Long (Buy) Position? Which is the better swing-trade (shorter term) position?

I will leave it to my readers to answer if they would like and I will follow up on this in my final entry of The Psychology of Trading.

Thank you to everyone for your feedback and reviews! I look forward to many more!