Becoming a better trader (or investor) involves much more than expanding your knowledge of markets.
While the vast majority of market participants may believe that it is, they are incorrect.
The secret to trading success does not lie in external knowledge, but internal knowledge.
It’s about understanding yourself, how you make decisions, how you react to adversity, and how you think about markets.
If you can gain enough mastery of yourself, trading success will follow.
This Collection will show you how.
Most people understand on some basic intellectual level that few outcomes in financial markets (and life) are certain – that is, luck is a factor.
In turn, the existence of luck means that market outcomes are rarely binary. How does this affect our ways of thinking about markets? More importantly, what does the 80/20 Rule have to do with it?
In order to answer these questions, we have to begin thinking in maybes.
Our human minds seem predisposed to jumping to conclusions when we are faced with a paucity of information. Reddit’s certainty of how their GME short squeeze could only turn out in their favor is a good example of this.
Retail traders saw GME’s price chart go vertical and somehow that was enough to convince them the stock could only go higher. Of course, more than a few of them learned the very hard way that certainty is not a luxury anyone in financial markets can afford.
Perhaps it would be wiser not to think in terms of “yes”, or “no”, but in terms of “maybe”, and “maybe” to what degree?
Going back to the GME example, a retail trader, when faced with the question “Can GME only go higher?”, instead of immediately thinking “YES!” and rushing to execute the trade, would pause and ponder different possible scenarios – the maybes.
Maybe GME won’t go higher, or maybe it will. Maybe the short squeeze ends a few days after the trade is executed. Maybe it doesn’t and the stock price really does go to the moon.
It doesn’t take much effort to work out a few basic scenarios of what GME may or may not do. If this abstract level of uncertainty is tricky enough, the bad news is that it only gets worse after this point.
The general (and most widely accepted) idea at this juncture is to apply what is taught in school, which is to run through an expected value calculation.
Unfortunately, as we will see, this calculation isn’t fit for purpose when it comes to financial markets. This is due to the nature of uncertainty in markets, which precludes any sort of precision.
Expected value is calculated:
E.V. = P(X1)×X1 + P(X2)×X2 + P(X3)×X3 + … + P(Xn)×Xn
Where P(X) is the probability of the scenario number (1,2,3,…,n) occurring, and X is the payoff the scenario gives.
As such, our hypothetical retail trader thinking about taking a punt on GME has to assign probabilities to each scenario occurring, as well as the payoffs he thinks are associated with each scenario.
Considering that our trader is already biased by all the GME short squeeze talk flying around, he will naturally overweight the most bullish scenario, say at 70%, and the associated payoff at $150.
The trader then considers the bearish scenario of GME’s share price falling like a stone, and weights this at 30%, since 70% + 30% = 100%, with the associated payoff -$150.
The expected value works out to be $60, which gives our trader even more confidence in going long GME!
Obviously something isn’t working correctly. How could someone come out of a thought exercise meant to highlight prevailing uncertainty with even more certainty ?
To be continued…
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.
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.
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