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!

Overview - My First 2 Published Positions

A recap of the positions I took today:

SCSS Long at 6.25/share for 500 shares. + .36/share end of day 1 for $180.00 profit. Will continue to hold until SCSS reaches price target I for first sell and price target II for second sell (see "A Risky Endeavor?")

DUG - UltraShares Pro Short Oil & Gas - Long at $39.34/share for 300 shares. + 1.15/share for $345 profit. Will continue to hold to reach sell off goal by tracking oil price movements and using technical analysis on the charts for DUG

So far off to a jump start because I picked some good entry points for $525 profit the first day of trading. These two trades have grossed me a 3.52% gain on the first day. My general goal is a 3% gain minimum per month on my overall portfolio, so I'm off to a good start.

I will be doing more extensive research on two other positions I'm attracted to as well as writing down some notes on something I call the tug-of-war which deals with general market perspectives.

Thanks to my readers so far. I've already received 2 emails and I 'm very excited to hear from more of you! Have a good evening.

First Post: My First Investment Position.

This is my first post as a blogger. I'm very new to this side of the blog concept but I have been an avid blog reader for some years (my RSS feed has about 145 of them). I love the idea of the blog, the unedited rawness that you find on the internet.

There's no need for the politically-correct softening down of certain topics. No need for the approval of a publishing manager then his manager and finally the general manager to get an article put through. There is just me, the writer, you the reader, and the medium; the blog.

I also love that the responsibility of editing lies solely on the writer. There is no team of proof-readers spilling drops of coffee and cigarette ashes across the pages of my work. In fact, there are no pages period. Just the clean desk.

Not my desk, though. My desk as always is cluttered even as I type this. A box of matches, an ash tray, a fresh pack of cigarettes with only one missing. One empty paper cup and another full of coffee. Speakers, monitor, telephone, and a few scribbled notes. But these are just the things that keep me going, the fuel. The stuff that really matters is slid into 8 Firefox tabs, a word document, a spreadsheet, and a picture viewer.

Which brings me to why I am here. I have thought about blogging for a few years now, but there were first of all several mental obstacles I needed to overcome.

The first was the easiest: Dare I put my thoughts out into the universe of billions of clicking surfers and reviewers? Dare I test my wit and intelligence against the masses? What if I am ripped apart by the old veterans of the roller-coaster landscape of online publishing?

Thankfully I have just come out the other side of a rather distasteful employment experience. To work for some people there just isn't enough money in the world. But that isn't my point. What I learned, the most relevant to this anyway, is that I no longer care. Either way it doesn't affect who I am as a person if someone is interested or disinterested in what I have to say. If they see my insight as valuable or invaluable.

The ball is in your court after today. I am only the referee, calling the plays as I see them.

The second and far more challenging thing was the topic for me to blog about. I don't want to be one of these universal bloggers who grab at everything around them or narrate their own lives to the general public. A reality television book.

This problem arises from the fact that I have many interests, and some of those interests I consider myself fairly knowledgeable. I am a jazz drummer of 13 years, I have played poker profitably both online and in B&M casinos for some years, I am working on a novel that I have several publishers interested in, I have run three successful businesses and sold them since I turned 17 years old.

And I have a profound love for the world of stocks, commodities, and all things investing-related.

That is the topic I chose and it is for one reason. The very same reason that I would never take a job at a bank or large financial institution.

The many resources out there for making profitable investments are almost all there for one thing: to make themselves money. Whether it be a large brokerage house that profits whether or not you make a cent or lose half of your holdings, a subscription-based advisory service, a black-box system that will only work until the market makes a single significant change - if at all, and the many other ways average investors try to make sense of the endless ocean that is the financial world.

The first thing I would like to demonstrate to my readers is that the markets all and one are driven by a singular thing. I will deal primarily with that in my next post. The second thing I will be doing is simply posting the exact positions I will be taking in my portfolio and the reason for taking my position. That is all.

You as a reader can choose to take this advice, ignore it, laugh at it, ponder it, write it down, anything you like. I am simply opening my own portfolio to the eyes of the public.

Right now I am researching several positions that I will be taking in the next 5 trading days. The first position I have solidified is in Crude Oil. Here is the link for the charts on light crude traded on Nymex

Crude Oil Charts

I will be taking up a short position on futures contracts for April 2008. I will also be using the Proshares Ultrashort Oil and Gas ETF found HERE, which is an excellent resource for people who don't trade in commodities options or futures. Proshares offers the only Short ETFs in North America and holds $9 Billion in equity. They are a very reputable firm and only charge a .95% annual handling fee (the average fee is around 2% so they are very inexpensively priced).

There are several reasons that I am taking a short position :

1. Timing: Oil prices generally take a 5-10% decline from January through May due to decreases in volume because the weather is warming across North America.
2. BIGGEST REASON: Oil prices have reached a top, which I will show in the following chart, and have formed a head-and-shoulders pattern coming down the other side. This generally means that a large crash-down in price will be occurring in or over the next 5-15 trading days. I am very excited to take this position.
3. Higher uses of coal in the last 3 years due to high-sulfur emissions has taken a chunk out of the oil market and OPEC is currently keeping demand levels at an inflated amount to cash in for a while. Once this "oil bubble" bursts the price will slide down.

My estimate is that the price of crude oil will be somewhere in the mid-high 70's by April giving me a tidy 20%+ gain. I will show you what I am talking about on this chart, and introduce you to a few of my cardinal rules.

RULE 1 - ALWAYS take a position you are at least 75% sure will run your way.

RULE 2 - ALWAYS set a stop-loss on your position that only risks a portion of your potential investment. In this case I am risking a loss of roughly $2.50/barrel versus a potential and projected gain of $14.00 - $20.00/barrel.

RULE 3 - Pick you entry Point - I will enter this position immediately as it has already hit its third top of the new downtrend. I did decide, when I started considering this position, that I would wait for a strong indicator in my favor. If you go to the charts for this stock and notice over the last month you will see that a clear head-and-shoulders pattern is formed and oil prices are poised on the brink of a decline. I chose my entry point at my estimated half-decline on the right shoulder to catch immediate gains and ride out profits.

This chart without revisions is provided by TradingCharts

This about sums up my first post. I would like to thank in advance anybody who takes the time to read what I have to say, and especially thank any of those who would like to add input to my posts. I greatly appreciate it.

Enjoy the holidays everyone. I will post another position very soon!