Cognitive Perspective: Think Differently For Better Results
You Need To Know This Key Difference Between Bulls & Bears
Understanding that the human reaction to data and headlines, that is emotion, is more important a driver of market prices than economic conditions, gives traders an extremely valuable perspective.
It allows them to take a step back and observe price developments with a higher degree of dispassion than if they were reacting along with the crowd.
All they have to do is be able to recognize how emotions manifest themselves in price action, and then act accordingly. But how does one identify if a price move is driven by emotion?
Think of market confidence in terms of trust.
Trust, between people, is built incrementally and over long-ish periods of time.
This same trust, however, takes but a split second to break; a misjudged decision, maybe even a too harsh word said in the heat of a moment, can be all it takes to undo years of work.
This asymmetric nature of trust applies to market reactions as well, and is expressed humorously in the Wall Street adage “Bull markets go up the stairs, Bear markets jump out the window”.
Bear markets are characterized by extremely quick and sharp drops in asset prices as market confidence plunges the financial system into a vicious cycle of margin calls, forced liquidations, and falling prices.
Trust is very quickly lost.
When asset prices finally bottom after the conflagration of liquidating longs runs its course, it is only natural for market participants to be extremely cautious about market and economic conditions. The question of further margin calls and failing counterparties are still very much at the front of their minds.
Remember that markets are simply a collection of humans (and their algos programmed to do the same things), making bids and offers.
Time is needed for them to work through the emotional trauma before beginning to grow in confidence that asset prices can recover.
Trust takes time to build.
Therefore, how quick and sharp a price move is can help traders identify what kind of emotional state a market is in, which can help them to understand the significance of turning points in markets.
Remember – emotion matters a lot in markets, confidence takes time to build and no time to break.
Do You Want To Make Money Trading?
Learn how to, and more, in our Trading Courses.
A Simple Way To Identify Fear & FOMO In The Markets
Blood on the streets! Panic in the air!
After watching markets print nothing but losses for weeks, bears seem to have exhausted themselves, with enough buyers coming in for the first up day in a long time.
You find yourself wondering if you should dip your toes in and put on a long…the best time to buy is when everyone is fearful after all, no?
But what if the sell off continues? The same people (which is everybody) who like to say “buy when people are fearful” are also the same people who say “don’t catch a falling knife”!
Confusion! What to do?
The first thing to realize is that in such situations it is almost always wiser to wait and see how price action plays itself out over the next few days. Bear in mind that a lot of the buying that occurs after a massive selloff tends to be short covering as short sellers take profits.
If the rally fizzles out and price starts to move down again, watch out for selling to get increasingly frenetic.
This more often than not culminates in one or two very long bars on the chart as everyone in the market rushes to sell out of their positions at the same time; mass liquidation in a word – FEAR.
If the rally continues and is confirmed with the market closing higher on consecutive days, especially if it tests the prior lows and rallies off them, it is time to pay attention.
Trying to trade this is still very tricky as short covering, especially at bottoms, tends to feel frenetic, leading to rallies that can be quite substantial, but fade quickly after a few days or weeks.
The rule of thumb here for those who insist on taking risk in these environments is that the quicker and larger the rally, the more likely it is that the move higher is a bear market rally.
Basically, the more the rally resembles a straight line up on a chart, the more likely it is to be a bear market rally, in which case the best thing to do is to identify the longer term trend. If it’s in an uptrend, a long could be a good idea, if it’s in a downtrend, waiting for prices to test a trendline would be a prudent move.
This rule of thumb works because straight line price moves are the opposite of mass liquidation; instead of people rushing to the exits, people are rushing through the entrance. This is a frequent occurrence in two scenarios: bear markets, and the end of massive bull markets.
In the case of bear markets, these straight line bear market rallies occur because people have either yet to fully recognize the severity of selling pressure, or jumped into a short covering rally with premature hope that the selling is over.
The quick move higher from the initial burst of short covering draws more and more people with “false hope” into participating in the rally, all thinking that the bear market is over and rushing to not miss out on the upside.
The same thing happens at the end of bull markets, as price deviates sharply from established uptrend lines, eventually displaying the same straight line behavior described above. More and more people get drawn in as they see everyone around them getting rich and think to themselves “I want in too”.
In an acronym, FOMO.
Do You Want To Make Money Trading?
Learn how to, and more, in our Trading Courses.
Why Not Knowing Can Help You Become Better At Investing
People like to know “things”. More specifically, people like to be seen as “knowing things”. The more knowledgeable, the better.
It’s even become a point of pride and a yardstick for measurement in society, where people who are deemed to be “intelligent”, or “smart”, are held up to have the highest chances of success (in this case, success is almost always narrowly defined as making a lot of money).
It is almost as if a cult has sprung up around the acquisition of knowledge, with the central creed being: Knowing More Things = More Certainty.
Unfortunately, as older and wiser folk among us can attest, the opposite tends to be true: Knowing More Things = Less Certainty, and learning is a process of removing certainty, not one of gaining it.
It is this Less Certainty that helps one appreciate just how little one knows, which, if you think about it, isn’t as paradoxical as it sounds.
The process of learning is, at its core, about assimilating knowledge acquired from different sources to execute actions or explain phenomena that occur in our lives. By definition, when we learn something new about a subject we are already familiar with, older knowledge is updated, corrected, or entirely replaced.
In other words, each time we “learn something new”, we simultaneously find out that we really don’t know a whole lot; i.e. the more we learn the less we know.
Take the example of gravity. Einstein’s General Theory Of Relativity did not just disprove Newtonian gravity, it also opened the doors to phenomena that scientists at that time did not know about, which have in ensuing decades, been proven to exist*.
In trading and investing, we need to appreciate that we know a lot less than we think we do. Accepting that our knowledge base is always going to change is an important step in realizing that most of the time, we simply do not know what will happen next.
And this is a good thing.
Not knowing is the best possible place to begin, as the mind is clear and open to learning new perspectives and discovering new ways of thinking and doing things.
After all, isn’t the best answer to being asked a question to which you don’t know the answer to in a job interview: “I don’t know, but I’ll find out”?
*If you are interested in this, google gravitational waves and/or black holes
Do You Want To Make Money Trading?
Learn how to, and more, in our Trading Courses.
Einstein Shows Us Why Perspective Is Important For Investors
Thought and knowledge are nothing more than a matter of perspective, subject to constant revision through the passage of time. What is taken to be “true” today can very easily be disproven tomorrow, likewise what is believed to be “false” today can be proven to be plausible tomorrow.
Even the most firmly held beliefs can be disproven and re-theorized.
Take gravity for example. Newton first came up with a conceptual framework of what gravity is in 1798, proposing it to be an attractive force between particles; essentially magnetism, even between non magnetic materials (like magic!).
Einstein then came along in 1915, and showed with his Theory Of Relativity that gravity is due to the curvature in the space-time continuum caused by massive objects.
You would think that the existence and scientific acceptance of a new theory in something as obvious as gravity would cause people to update their views, but… no!
Most people still think of gravity in Newtonian terms, which is largely because schools still teach gravity in Newtonian terms.
Is Einstein’s understanding of gravity what it really is? Chances are no one will ever know, but it is possible, even likely given a long enough time frame, that future physicists will propose new theories of gravity, its nature, and what it is or is not.
The gravity example should illustrate how easy it is for people to hold on to misperceptions.
The human mind, for whatever reason, seems to like to take what it reads, is told, or is taught without question.
This means that we generally do not think or even wonder what the underlying assumptions are. And, if there are any, if those assumptions are relevant and can stand up to rigorous scrutiny.
Moreover, the example raises a serious question: If something as basic as gravity can be misperceived by so many in the general population for more than a 100 years, in the age of the internet no less, how many more misperceptions exist?
Specifically, how many more misperceptions exist in the markets, which are filled with uncertainty and ever changing relationships?
Knowledge is not fixed, and it never has been.
Thinking that knowledge is fixed has the potential to be very dangerous, especially when dealing with risk in dynamic, complex systems, and can lead to one clinging on to theories that no longer work. Needless to say, this is a sure way for a trader/investor to destroy their PnL, or at the very least undergo a deep and prolonged drawdown.
To make matters worse, it is not uncommon in markets to find that theories and strategies that used to work can suddenly reestablish themselves and become viable again.
A good example is the inverse relationship between the performance of growth and value stocks in equity investing. Investing in value stocks tends to do well when investing in growth stocks is going through a run of low performance, and vice versa.
Does this mean that value and/or growth investing is not a viable way of thinking about markets? Not at all, they are viable, but only when the time is right.
In the absence of being able to know in advance when the time will be right, the best we can do is to remember that knowledge is but perspective, and to change the way we think about markets as time and circumstances evolve.
Remember – Einstein!
Do You Want To Make Money Trading?
Learn how to, and more, in our Trading Courses.
You Need To Think In Relatives When Investing
One of the first things new currency traders learn is that theirs is a market of relatives. Every currency is always quoted against another, hence a currency has to go up or down relative to another one.
Saying the EUR went up is a meaningless statement; because – relative to what?
For the statement to have any proper meaning, one has to say the EUR went up against the dollar, or the pound, or whichever currency. (Although most people will assume vs the dollar if no reference currency is mentioned).
Turns out, asking “relative to what?” applies to far more than currency markets.
Headlines provide examples of not seeing the relatives. Take for instance a simple headline about a company’s earnings, which states that its revenues increased. That’s all well and good, but relative to what?
If revenue increased by 20% but costs increased by 25%, then the revenue increase is no longer a positive. Taking another point of comparison, if revenue increased 30% QoQ, that sounds absolutely amazing, but what if revenue is seen from a YoY perspective?
Maybe from the YoY point of view, revenue was flat, and further investigation reveals that at the same point in the calendar last year revenue jumped by about 30% as well. Therefore 30% QoQ jumps between these two quarters are nothing extraordinary, just a matter of seasonality.
All of a sudden, the headline does not look so bombastic anymore.
Here’s another example to further drive home the point:
Always remember to ask: relative to what?
Do You Want To Make Money Trading?
Learn how to, and more, in our Trading Courses.
Get a different perspective on all things trading & investing every week!
