Category Archives for "Free CMU"

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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