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!

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. Dictionary.com 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. Dictionary.com 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"

Buying for the New Year

I hope that everyone is done their Christmas shopping. I had to dodge down to the mall last night to exchange a gift because the particular item I bought was just purchased by the person I was supposed to give it to. Bad Luck.

Anyway, as I was hemmed in traffic, I decided to counter my road-rage (to which I am easily prone) with some deep thinking. So I sparked a cigarette with my Tim Horton's (I have been a shareholder since its I.P.O.) and pondered away.

I sold my stop-loss point on DUG as of Friday, as it hit and carried on through the rest of the day. A small loss at the opportunity for great profit.

But buying opportunities are out there for me. By the time I got home I know what I was going to write about. After some scribbled notes last night, I will put a few generic stock tips out there for people interested in buying right now.

The first note to make is that we are in what is referred to as a sideways market. The S&P 500 has been hovering between 1400 and 1550 for almost a year now with subprime woes smashing it down and individual, surprising company growth pushing it back up. Many factors are involved in this situation but the main point to take away is that over 75% of large-cap stocks practically mirror the S&P 500 barring extraordinary circumstances either bad or good. I.e. the large-caps are moving sideways as well.

Charts on this page provided by Yahoo! Finance

This has created many buying opportunities for value-investors, but even more importantly it opens the doors for smaller companies to grow as the large-caps tighten down the screws to weather the storm.

There are a few things you as an investor can do:


1) Follow those large companies that have been most hurt by the economic woes of this sideways market. Citigroup (C) has lost over 44% of its share value because of the sub-prime problems of the last year. However they haven't lost 44% of their business. So, when the tables start to turn (i.e. watch the chart. If Citigroup finds a strong support that it bounces off of a couple of times, it might be a good time to buy and catch a chunk of that 44% downturn and maybe even scoop up a dividend while you're at it.

But more importantly is this: The entire financial industry has taken a very solid hit because of the sub-prime mess. Even banks that had very little sub-prime loans in their portfolio. So if you buy one of those at a good point and hold, it will retract and GAIN on the companies hurting from defaulted loan losses.

All it really takes is a good eye and an ability to take advantage of the panic of other investors who are less intelligent or rational than you are. If you look at SCSS, I have made over 1.00/share in less than a week from the panic-selling of other individuals.


2) This is the opportune time to buy small-cap companies that have been trying to squeeze precious market share from the big players. Well now is their chance to do just that as many of them are cutting back operations and budgets, laying off thousands of employees, and simplifying product offerings.

This is a small company's dream! One small cutback by a large company might let the little guy DOUBLE his market share overnight. And by doing that they suddenly have twice the revenue with the same or close basic overhead and the addition of only variable costs. The result: A huge spike in earnings which draws publicity, which means a flood of money from the two-steps-behind, news-following investors. But we've already beat them to the punch, and every time one of them is willing to pay a cent more for a share, that's another cent of profit to us.

On a side note I just purchased E*Trade Financial after hours on Friday. This is another of the companies that have been hammered the last year (-85%). But they are making big changes (I am happy for one because I make some of my trade with E*Trade) for the better and I see their share even doubling over the next 12-18 months. My favourite part of this purchase is a review of their key statistics. The company's intraday market-cap (the number of shares x the price of the shares) is only $1.5B, while their actual real enterprise value is $21.5B, and it is trading at a MEASLY 3.5 P/E (share price to earnings ratio). In a situation where people have been dumping this share left and right for as long as I can remember, I think it's finally time for a turnaround.


I got into the stock for $3.60 just before the close for 1000 shares. I am setting my stop in at $2.50 because I am expecting returns of $6.00 - $10.00/share over the next year, a 50% retraction on the past 12 month's massive decline. If you refer to the chart, you will see an outrageous increase in volume (i.e. panic selling) as the stock price plummets.

Many of these sellers will start to buy back the stock at the first sign of a few good headlines and I will profit because I am one step ahead of them. Even if this stock makes it halfway back to its valuation I stand to make a profit of $6,000 to $10,000 versus a maximum potential loss of $1100.

The final thing I like about E*trade is that is far smaller than the big players in the sub-prime losses. For example, Citigroup has 1.06 TRILLION in cash assets to manage and thousands of offices. E*trade is much more flexible and can innovate much faster to offset losses.


And finally,

3) Because the US market is in the middle of stagnation, for the near future, it pays to take a look at foreign markets.

China is not a good choice for the beginner or average investor, because it is so over-valued as a whole right now that you have a very high chance of hitting a bubble stock that will crash down on you. (On the flip-side, if you wait out for a while until the deflation starts, you can make a pile of money short-selling the overbought stocks).

Emerging countries like Brazil are an excellent place to look. This country is starting to develop at an exponential rate and there are billions to be made. I have been reviewing Brazilian stocks for almost a year now and have several companies in my long-term portfolio, every one I purchased at a steal and has made solid growth.

Just remember that there is always some place in the world where your money will grow. It just might not be as close to home as you'd think.

Merry Christmas everyone! I will post again before the new year.

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