Category Archives for "Free CMU"

Oct 04

CMU: The obvious trade everyone screws up

By Jani Ziedins | Free CMU

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.


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Sep 27

CMU: Why popular investing strategies don’t work

By Jani Ziedins | Free CMU

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

Why popular investing strategies don’t work

The library, bookstore, and late night TV are filled with “surefire” investing strategies that will allow you to quit your job and live a life of leisure. At least that is what the flashy dust jacket or energetic pitchman promises us. Follow their extra special fundamental screen, chart pattern, or buy a piece of software and you are well on your way to printing money. Sounds great, doesn’t it? If only it was that easy.

The first thing to realize is the stock market is largely a zero-sum game. That means under most circumstances, one trader’s profits come directly out of another trader’s pocket. This isn’t always a bad thing and both of sides can earn handsome profits in a rising market. But like every pyramid scheme, the last person loses out.

Profit opportunities arise in the stock market when prices are not where they are supposed to be. This is commonly referred to as an inefficiency. For one reason or another a stock’s price is out of alignment. Maybe sentiment is overly bullish or bearish. Maybe the public doesn’t know the company’s sales are about to miss expectations by a wide margin. Or maybe a secret product is about to be announced. Whatever the reason, the stock is about to experience a large move and owners are rewarded for being in the right place at the right time.

One of the most important things to realize about these profit opportunities is they are limited in potential. Not everyone can profit from the same opportunity. If too many people buy a discounted stock, their buying increases the stock price until the discount disappears.

Think of these profit opportunities like a $100 bill lying on the street. If I find it by myself, I keep all $100. If a good friend and I see it at the same time, we split it and both of us are $50 richer. If five friends come across the $100, each person benefits by $20. If 1,000 people find the $100, each person gets ten cents and at that point it is hardly worth the effort.

This same phenomena occurs with popular investment strategies. Let’s say a hypothetical formula identifies stocks that are undervalued by 20%. If we keep this strategy to ourselves, we make a lot of money. But if we publish a book with our strategy, a lot of people are going to start chasing the same 20% discounts. The more people looking for them, the harder it will be to get there first.

After missing out a few too many times, some investors decide they are perfectly happy with a 19% profit. Rather than wait for the stock to fall 20%, they jump in early so they don’t get left out again. Soon a lot of other people start doing the same thing and because of all the early buying, the stock never falls to a 20% discount.

Then some people decide 18% is good enough and they start buying even earlier. This process repeats over and over again until the discount shrinks from 20% to 10% to 5% and even 1%. The process of beating each other with the same investing strategy only stops once the profit opportunity is so small it isn’t worth the effort.

The above describes value investing, but the same process occurs in momentum stocks too. Let’s say there is a great stock screen that identifies companies with the largest profit growth. The strategy tells us to buy these momentum stocks when they breakout from a consolidation because that is when they have the most explosive upside. But soon everyone is chasing the same growth stocks at the same time and the breakout moves so fast few people can buy it before the stock is too far extended to buy safely.

Frustrated investors who get left behind a few too many times commit to buying the stock a little before it breaks out so they don’t get left behind again. It doesn’t take long before more and more investors are buying the stock before it breakouts and soon the buy early crowd is causing a breakout before the stock is ready. Without a sufficient consolidation, the breakout fizzles and tumbles back into the consolidation, triggering everyone’s stop-loss. Rather than make money using this surefire investing idea, all the followers are sitting on losses.

Every popular investing strategy stops working once too many people start using it because the crowd quickly distorts the price-action that made it work in the first place. They sucks up all the profit potential and it is hardly worth the effort. Or the crowd triggers fake breakouts that suck everyone in and then spit them out with less money than they started with.

Dogs of the Dow, value investing, momentum investing, technical analysis, candlesticks, cup-with-handle, etc, etc. When any strategy gets too popular, it stops working. The very act of people following a strategy changes it and that is enough to destroy the profit potential.

But don’t despair, there are a million different way to profit from the stock market. The key is to find a strategy that fits the way you look at the market and then add your special sauce. There is nothing wrong with starting with an existing strategy, but you must bring something extra to the process to make it profitable. Maybe you are a technophile and have a knack for knowing which products will be a hit before Wall Street figures it out. Or maybe you know which laggards are about to turn things around. Something, anything, but you absolutely must have that special sauce otherwise you are just one of clones fighting over the same $100.

In future Cracked.Market University pieces I will help you find unique ways to look at the market that will help you find your special sauce. Be sure to come back for more free CMU posts.

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Sep 25

The most powerful technique for analyzing the market

By Jani Ziedins | Free CMU

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

Many traders approach the market by trying to predict the outcome of an event and profit the market’s expected reaction. If the Fed raises rates, then the market will respond this way. If unemployment misses expectations, the market will move that way. Cause-and-effect analysis works well in everyday life it is natural to bring this line of thinking to the market. Unfortunately this method fails to account for how markets work and this omission explains why so many people lose money.

Traders often predict the outcome of a market moving event correctly, unfortunately they are not as good at figuring out the market’s reaction. This leads to the popular misconception the market is “fixed” and “rigged”. This couldn’t be further from the truth and I will cover this fallacy in another blog post. In the meantime just take my word for it the market is an equal opportunity humiliator and does a fair and equitable job screwing over both retail and institutional investors. When you lose money, it isn’t because some cunning market villain stole your money, it’s because your analysis is missing key ingredients.

In my two decades of trading, far and away the most effective tool I use in identifying market’s next move is studying what it is NOT doing. Almost everyone obsesses over what the market is doing and tries to to fit these moves into their narratives, whether that is fundamental, technical, or a hybrid of the two.

The problem is looking at what the market is doing inevitably leads us to thinking about what it “should” be doing. When the market doesn’t do what we think it should be doing, rather than admit we are missing something, our natural instinct is to argue with the it. This response is incredibly counterproductive and leads to more lost money than every other mistake traders make.

Take the current situation with North Korea. This is obviously a bearish development and there are grave consequences for everyone involved if this situation escalates beyond words. Despite these ominous warning signs, the market continues to hover near all-time highs. This leads many people claim the market is complacent, stupid, and worse. Common sense tells us the market should have sold off dramatically on these dire headlines. But we didn’t. That mean either the market is wrong, or god forbid, we are wrong. We couldn’t possibly be wrong, so obviously the market is wrong.

Rather than acknowledge the market’s strength, these critics double down and claim it will only be time before prices crash and they are proven right. The problem is these traders are missing the incredibly powerful signal the market is giving us. This market is not selling off, not because it is stupid, but because it is unbelievably resilient and strong. There are few things more bullish than a market that refuses to go down on bad news. Everyone who is spending all their energy arguing with this market is about to get run over.

If this market was fragile and vulnerable, it would have crashed a long time ago. Rather than argue with it, we should acknowledge it. Better yet, let’s profit from it! A market that refuses to down will eventually go up.

The same thing happens on the opposite side. A market that fails to go up on good news is a clear warning of potential exhaustion. A recent example is AMZN spiking on the acquisition of WFM. Since then the stock is down 13% and it definitely looks like it is struggling to find new buyers.

Asking what is the market is not doing gives a trader great insight into which direction a stock is inclined to go. A market that refuses to go down on bad news has a lot of upside potential in it. A stock that fails to go higher despite all the praise it is getting is a clear sign new buyers are scarce and at the very least it needs to rest and consolidate recent gains.

I have a large assortment of tools and techniques I use to evaluate the market, but this is far and away the easiest, most powerful, and most profitable tool I use.

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Sep 20

Contrarian Investing: Why most people screw it up

By Jani Ziedins | Free CMU

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

Spend any time following the market and you will come across the term “contrarian investing”. For those that don’t already know, this investing strategy takes a position in the opposite direction as the larger crowd. If the crowd claims something is a sure-thing, the contrarian sells it. If the crowd is rushing for the exits before things get worse, the contrarian jumps in and buys the dip. That description is simple enough to understand, but less clear is why this counter-intuitive trading strategy works so well and how come the crowd gets it wrong so often.

The first thing to realize is the crowd’s ideas are not wrong. Wisdom of crowds is a very real and powerful phenomena that I will cover in another blog post. For the time being, trust me when I say the crowd is smarter and more insightful than any of us can ever hope to be. But where following the crowd’s ideas gets investors into trouble is these ideas are already priced-in. That means most of the profit from investing in these ideas has already been made. I will use the following basic supply and demand model to show you how this happens.

The first thing to understand is stock prices are set exclusively by active buyers and sellers. I will dig deeper into this topic in another blog post, but for the sake of this discussion, people who sit in a stock or stay on the sidelines don’t affect the price. Only traders actively trying to buy and sell the stock determine the current market price. The price they agree to is the exact balance point between supply (sellers) and demand (buyers) at that precise moment in time.

The other key concept in this illustration is people trade what they think. If an investor loves Apple and he believes the stock is going to double or triple, we can be fairly certain this investor is already fully invested in AAPL. It doesn’t matter if a trader uses intuition, fundamentals, or technicals, as soon as he is convinced a stock is a good buy and he has the money, he buys it.

But the thing to realize is no matter how much this investor believes in this stock, once he buys, he places his bet and from that point forward is simply a passenger on the market’s rollercoaster.

If this is early in the process and the investor’s point of view is unique, he can spread the word and encourage other investors to follow his lead. But as his view becomes more and more popular, it is harder to find new people who don’t already believe in the idea. At this point the crowd of believers is so large that new recruits are hard to find. Even though owners have never been more optimistic, serious problems arise when there is no new money left to buy the stock.

Remember, price is the exact point where supply and demand are balanced. If we cannot find new buyers willing to join this party, it doesn’t matter how enthusiastic the crowd is, demand shrivels up and is overwhelmed by supply. The crowd is still extremely excited about this stock’s future, but without new buyers to keep pushing the price higher, supply and demand forces punish the stock.

This is an example of a bubble forming and the subsequent climax top, but the exact same process happens in reverse during capitulation bottoms. “Sell now before things get worse”, but the scariest point is usually the bottom of the dip because that is where we run out of sellers. Once that happens, supply dries up and prices bounce. Headlines stop mattering when no one is left to sell the bad news.

While these are extreme examples of climax tops and capitulation bottoms, the same process happens to a lesser extent every day across every timeframe. It’s no secret prices move in waves and almost everyone acknowledges this on a cognitive level. Yet every time prices move too far one direction or the other, rather than acknowledge this is just a normal and healthy gyration, human emotions take over and we assume this small move is the beginning of the next big move.

We can call the previous section Part 1. This is most obvious example of contrarian investing because it goes against the market’s price trend. But just as important to the contrarian investor is Part 2, when he goes along with the market’s trend.

All too often people mistakenly think they are contrarian investors when all they are doing is arguing with the market. If a price is going up, they sell it. If the market is going down, they buy it. At this point many of you are scratching your head because that sounds exactly like what I described in Part 1. Isn’t it?

Nope, not even close. Don’t feel bad, this is an easy to mistake to make and it costs a lot of smart people a lot of money every day. Contrarian investing is not going against the price or the trend. Never forget price and trend have nothing to do with contrarian investing! The only thing that matters to the contrarian is what the crowd thinks.

More often than not the contrarian trade is actual follows the market trend and buys something that has gone “too far”. Or sells something that has gone “too low”.

I will use AMZN as an example. Two years ago the stock was “unbelievably expensive” at $400 and its valuation was widely viewed as “unsustainable”. Yet today AMZN is trading near $1,000! How did that happen? Quite simply,  the crowd didn’t believe in Amazon. Rather than have too many people buy the stock at $400, too few people were buying it and there was a lot of upside opportunity left in it.

Never forget contrarian investing is going against the crowd, not the price. Don’t make that costly mistake when you are tempted to short something that is “too high”, or buy something that is “too low”. More often than not the right trade is the exact opposite of the one you want to make. That’s because our primal instinct compels us to become a member of the crowd and believe what the crowd believes. This is a fascinating topic that I will save it for another post. Stay tuned!

I’m excited about this new series because my head is overflowing with ideas and insights that came from two-decades of trading experience. I hope you come back for the next post. 

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