CMU: The obvious trade everyone screws up

Welcome to the new Cracked.Market University educational series. Look for new articles every Monday and Wednesday.

Everyone knows the market moves in waves. Unfortunately most traders forget this important fact when planning their next trade.

All of us come to the market with biases. Extrapolating trends is human nature and we cannot help ourselves. Bulls insist the economy is fine and the rally will continue for as far as the eye can see. Bears believe wholeheartedly the economy is a sham, the market has gone too-far, too-fast, and we are on the verge of collapsing.

While all of us feel one way or the other, the question we must ask ourselves is how often does the market actually rally for as far as the eye can see? How frequently do prices collapse? If these are such rare events, why do most traders think extreme events are around every corner? The rarest predictions is the market will go a little higher before it goes a little lower, or a little lower before it goes a little higher. Who dares make such boring predictions?

I have read claims the market trades sideways 60% of the time. While I haven’t verified it myself, twenty-years of experience trading stocks tells me this number is definitely in the ballpark. Prices go up for a while, then they go down for a bit. Sometimes they make higher highs, other times lower lows, but the market always moves in waves.

The problem is most traders convince themselves every move higher or lower will continue indefinitely. When the move goes the direction of their bias, their confidence swells as the market’s price-action confirms their ideas. This confidence causes them to rush headfirst into a big position before they miss the trade they have been waiting for. Unfortunately most of the time their confidence doesn’t come until the market has already made a sizable move in the direction of their bias. In the bull’s case, when the market is making a higher-high. The problem is confidence is highest just as the last of the buyers are rushing into the market and prices are about to slip back into the trading range.

When a new trade falls into the red so quickly, confidence is shattered and replaced by uncertainty and fear. Traders initially convince themselves they can hold through a brief pullback because they are still believe they are right. When that doesn’t happen, doubt grows until vulnerable traders bail out because the pain of regret grows too strong. This selling pressures prices further, causing more nervous owners to sell, further pressuring prices. The downward spiral continues until we exhaust the supply of nervous sellers. Unfortunately for these reactive sellers, prices rebound not long after they bailout.

On the other side, bears have been emboldened by this dip and they start loading up on shorts just as the market starts making fresh lows. Their predictions of a collapse are coming true and they don’t want to miss out on all the money they will make. Yet just like the bulls, their timing is all wrong and no sooner than they jump in, prices rebound and they start losing money.

These waves of greed and fear occur in every timeframe from minutes to years and they suck in novices and pros alike. But it isn’t all bad. The stock market is largely a zero-sum game, meaning one person’s loss is another person’s gain. Those of us who us who understand the psychology behind these moves and can control our impulses profit by selling greed and buying fear. While that sounds easy, executing it successfully is one of the hardest things to do in trading.

The problem is we are herd animals and our survival instincts wired us to adopt the mood of the crowd around us. When everyone is happy, those feelings of calm and complacency are hard to resist. When everyone is scared, we grow fearful and the fight/flight instinct dominates our thoughts.

The most important thing to remember about dips is they always feel real. If they didn’t, no one would sell and the market wouldn’t dip. Cognitively acknowledging most dips bounce is the first step in overcoming our primitive instincts. Same goes for surges in price. Just when everything feels the most safe is when we should be the most nervous.

In August the crowd was predicting doom-and-gloom. They were wrong. Several weeks later we are making new highs and everything looks good. That said, I have little doubt these gleeful bulls will prove to be as wrong as the overconfident bears were several weeks ago.

Never forget the market moves in waves. It always has and it always will. After several weeks of nearly non-stop gains, it is normal and healthy for the market to slip back to support. But just like how this breakout isn’t racing to the moon, don’t fall for all the predictions the next few down days will lead to the next market crash.

There are so many exciting ideas I only briefly touched on in this post that I look forward to expanding on in future posts. No matter what the fundamentalists and technicians claim, market prices are driven by human psychology and understanding that is the first step in unlocking the market’s next move. Sign up for Free Email Alerts to be notified when my next piece is published.

Jani

f you found this post useful, share it with your friends, colleagues, and followers!

If you want to be notified when new posts are published, sign up for Free Email Alerts.