Trading Psychology
By Zak Mir of Zaks-ta.com*
Posted: Jan 27, 2006 Looking at the psychology of trading is a fascinating study when viewed from the perspective of history, sentiment and crowd behavior.
History:
Just about the best anecdote concerning any market is from August 1929 when the roaring bull market of the 1920s had reached a peak on Wall Street. When Joseph Kennedy was given a tip to buy “oils and rails” by his shoeshine man, he knew it was time to get out. Rather strangely, there is a similar anecdote doing the rounds regarding Rockefeller selling out before the 1929 Crash after being given stock tips by a taxi driver.
History teaches us that, just as the individual traders should avoid peaks and troughs of emotion when trading, emotional markets going through bubbles and depressions should also be avoided. In recent years, it has been the tech bubble of 1998 to 2000 and the bear market that followed that were both equally volatile and excessive periods.
Sentiment:
There are people who invest in the stock market on the basis of fundamental research, those who use charts and a third group that just follows gut instinct. For people who have been associated with the financial markets a long time, it becomes increasingly apparent that fundamentals or technicals alone don’t so much influence what an index level or a stock price may be at any one time. Instead, it is just as much the attitude or sentiment that those who are buying and selling are experiencing that drives markets.
Obviously, this is something difficult to quantify, but it is certainly something we all recognize when we see it. For instance, at the beginning of December 2005, one can say that the hottest commodity market is copper, closely followed by gold. What has been interesting since the beginning of September is the way the “top” market has moved away from crude to the metals. Indeed, one could argue that gold only started to take off once its main competitor, oil, started to fade.
The Crowd:
While it may be rather harsh to describe traders as being in a state of permanent civil war, this is not that far off the mark as far as the mechanics of trading are concerned. For every winner, there has to be a loser, and your winnings will come from someone else’s losses. In addition, it is in the nature of the markets that the highest number of sellers occurs when prices are at their lowest, and the greatest number of buyers occurs at the top.
A neat trick used by short-term traders is to think about whether, when they are buying, they are anticipating everyone else doing the same thing at that same time. It may sound strange, but, from a strategic point of view, it is really best if you do not imagine anyone else trading when you are. Buying or selling on high volume can just as easily be other traders panicking in or out of a position as piling into a winning trade.
The best times to enter a market are the quiet periods when volatility is low, and you have less chance of being stopped out.
Examples:
The Party Is Over: PartyGaming
This was one of the bull highlights of the summer of 2005 and, although the rug was certainly pulled from underneath them by a warning from the UK company in September, as much as anything, there was a sentiment peak for the gaming sector. It is fine to get on the bandwagon of a one-way bet, but bubbles tend to burst; slow punctures are rare.
Google: A Bubble Waiting to Burst?
At this rate, Google should be $1,000 by the end of 2006, but, even if this happens, you have to admit that there are many who regard the company as being able to walk on water. It may be for some time to come. However, at some point, there may need to be a correction.
So, it’s just as you’ve known all along, but it certainly deserves a reminder now and again: Learning from history and avoiding emotion and the crowd mentality keep you “on the straight and narrow” when trading.
*Reprinted (and modified) with permission from Zak Mir of Zaks-ta.com
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