Passion

"Without passion man is a mere latent force and possibility, like the flint which awaits the shock of the iron before it can give forth its spark."

~ Henri Frederic Amiel

Bias and emotion in trading

As most trading psychologists will tell you, our emotions can play a big role in our trading decisions.

It will be clear to budding trading psychologists that a bad trade can make you feel upset, and possibly lead you to act in a destructive, emotive manner.

An example of this is the trader who decides to hold onto a losing trade out of pride, or fear of having to admit that he or she must take a loss.

On the other hand, a trade that’s going well will make the trader feel happy, and either lead to positive consequences (quitting while you’re ahead) or negative consequences (growing overconfident).

One aspect many trading psychologists fail to examine, however, is the impact of our emotions at the beginning of – and even before – a trade.

That is, not just the emotional response we get from a market development, but the emotional bias we put into deciding on a trade.

Beginning with bias

Research has shown that traders will slant their estimate of risk going into a trade based on cognitive biases and emotional reactions.

This mind-set can influence our perception of financial data. Strangely, we see this happening often with traders who have been playing the market for a while.

Experienced traders may have seen a trade go one way nine times out of ten based on a similar set of circumstances.

So, when these circumstances crop up in the market, the trader feels that they already know what these circumstances mean.

Maybe so; but maybe not. The trader is coming into the trade with a bias based on a general feeling, and may not be taking into account all of the particulars.

Stay alert

Part of trading is having an awareness of the overall market. Humans are intuitive, and are capable of sensing subtle market patterns.

If you’re biased or emotionally aroused going into your trading decision-making, however, you may be blind to these subtle market patterns.

Biases and emotions can mask little warnings signs going into a trade, and cloud our view of new market relationships.

The way the market works is complex, and that’s why you need to have your feelers out to sense all these factors.

Keeping emotions and bias in line

It’s ridiculous to think that every trader works without emotion, because emotions are part of our psyche.

That is, emotion should be used constructively. Emotion is usually key to being a trader, because you need the drive to trade in the first place.

It’s all about keeping focus and leaving your biases at the door. The point is not to reduce emotion, but channel it in a way that builds consciousness, not reduces it.

So, remember, even before entering a trade, check whether your mind-set could lead you to cloud your judgment as you’re mulling over the data.

Mostly, ensure that you are conscious of all of the available data, and not letting excitement lead you to overlook bad signals – or negativity to overlook good ones.

Look at each new trade as a fresh trade, no matter how it might look like a textbook-copy of an old one, and remember that although history can repeat itself, new events can rewrite history.

Ignore the open, focus on the close

Plenty of novice traders understand that charts are important, but it can be confusing trying to figure out which signals are important and which signals are just noise.

All technical analysts agree one of the most important signals is the closing price. However, it’s not just the closing price that counts – it’s the closing price in relation to the day’s action that really counts.

The end of the day is when the professionals play

In general terms, most technical analysts view the closing price for daily sessions as holding more importance than closing prices for, say, five-minute periods.

This is because the end of the day is when key players have to fill orders, and they’ve often made judgments on whether to enter (or sell) according to the day’s action.

Other periods, like five minute or hourly charts, are arbitrarily chosen by you and don’t provide the same level of information.

However, all markets will have certain intra-day charts that are mostly used by professionals, and, in those charts, the closing price will give you important information.

What are you looking at?

There are two important pieces of information you can get from the closing price.

The first piece of information tells us which side was in control at the end of the session. We do this by looking at the close in relation to the range. At the top of the range, the buyers are in control. At the bottom, the sellers rule.

This is important because, as we’ve discussed, the key players are usually viewed as in control at the end of the day. Also, the close of the day should be most likely to signal what will happen tomorrow.

The second piece of information tells us how committed one party is. We do this by looking at where the closing price is in relation to the open. If is it is only marginally away from the open, then there is little commitment.

But if the closing price is significantly away from the open, then this piece of information gives you a good indication the day’s trend is likely to continue.

The first rules of Trading

Sometimes traders can get emotionally invested in a stock or a trading strategy and see their bank balance shrink to zip.

That’s because it’s easy to get excited about trading and forget the reason why you’re investing in the first place – to make money.

And in order to make money, you have to use your head and manage your money against risk.

Watch your bank balance!

You must remember that your number one goal in investing is to protect your trading capital.

Money management is what separates the successful traders from the ones who crawl home with their tails in between their legs (and their wallets empty).

The most sensible way to manage your money is through keeping your trades small (also known as the “basket approach”) and never average down (also known as increasing your holdings in falling stocks).

Profit versus loss

In managing the money set aside for investing, one must always remember to compare the potential size of a loss with the potential size of a profit.

Just because someone profits on trades most of the time doesn’t mean they’re ahead.

They may still have more profits than losses but lose out on the whole, because the magnitude of their few losses is severe.

On the other hand, those who only make a small proportion of profits relative to losses may do well because their losing trades aren’t significant.

Some intelligent grey heads have noted that it doesn’t even matter how many of your trades are profitable so long as you use intelligent money management principles.

Eye on the ball

It’s easy to get distracted by “trading noise” – the entry decision, the exit decision – the day-to-day or minute-to-minute movements of a stock.

However, your overall goal as a trader should be to preserve your capital.

In other words, take care of your money. This may sound like the kind of sensible advice your mother would tell you, and you might be dismissively thinking, “I know, I know!” But you’d be surprised at how important this message is – and how often people forget it!

In the end, what you’re doing is trading to survive – if you can survive, you can keep trading, after all.

And the longer you trade, the better your chance of trading success.

The six stockmarket viewpoints

Each of our individual personalities lead to various ways of viewing the world, so it should come as no surprise that different personalities will accompany different viewpoints of the market.

How do you view the market? Esteemed trading psychologist Brett Steenbarger theorized that there were six common ways in which stockmarket enthusiasts view the market, as a form of “cognitive lense”.

Steenbarger’s six market views are listed below. Ask yourself whether you identify with any of them – and whether you are familiar with the positive and negative aspects of each view, as well as the likely outcomes of each approach.

1. A trader views the market as an enemy to be conquered

This viewpoint seems to depict the market player as a conquering hero that feels that they have the power to overcome the market, if they so choose.

On the other hand, it can be interpreted as the type of trader or investor who feels that the market, as an enemy, is a threat – a threat that is too powerful to be conquered.

Though it is good to be confident, the former school of thought could lead a trader to overconfidence; the latter to underconfidence.

And while it is important to recognise at times that the market is something of a creature that is out of our control, it is also important to recognise that the market is never your enemy.

Those who blame the market for mistakes are likely to succumb to negative emotions, and overlook the fact that their own mistakes are driving a bad trade.

You cannot “conquer” the entire market, but you can conquer your own trading fears and set up efficient and successful trades through discipline, training, and using you desire to trade in a positive manner.

2. A trader approaches the market as a puzzle to be solved

We all feel at times that the market is a puzzle to be solved. This occurs when the market moves in ways we don’t expect it to move.

The recent bear market is a good example of this. Despite warning signs, no one really saw the global economic downturn coming – and it his us hard.

Though it is smart to acknowledge that the market in general can be puzzling at times, this “bigger picture” shouldn’t distract you from each of your smaller pictures – your individual trades.

Spending too much time analysing why the market is moving the way it is can lead to a kind of analysis paralysis – you fail to closely follow your trades whilst you puzzle over the overall picture.

On the other hand, it is a strength to engage in curiosity over the market, as this can lead to greater learning about the market. Just don’t run away with the idea.

3. A trader sees the market as a paradise of potential riches

What a starry-eyed viewpoint this one is! However, it would hard to find a trader who hasn’t felt this to some extent.

This sentiment is especially common amongst traders who are beginners. The lure of money, after all, is a big part of the reason why you get into the stock market to begin with.

Desire for money alone however does not a good trader make. Despite what many stock market films will tell you, greed isn’t good – greed can blind you, and ramp up your overconfidence.

It is important to view the market with a positive mind-set, but your focus should be on the strategy used to make money, not the ideal of money.

4. A trader regards the market as a mistress to be wooed

This view involves the mind-set where a market player may think, “Persistence alone will pay off in the end.”

In romantic comedies, our wannabe-Romeos will go to creative and outlandish ends to win their women. In real life, this sort of behaviour lands you in jail, or at least with a restraining order.

Okay, the market is a different field altogether – but restraint IS important. Constant persistence is not only draining, but it can give you tunnel-vision. Wooing is a costly action because it is time-consuming.

Because the concept of wooing is also interwoven with the idea that good luck will settle your end game, this can also be a dangerous mind-set to take on. The stock market is not the same as gambling, and you’re not relying solely on luck. You need to employ thinking and be prepared to learn a great deal if you want your trades to succeed.

5. A trader views the market as a dangerous minefield

This is smart thinking in a lot of ways, because this mind-set acknowledges that there will be mines ready to explode in the stockmarket. Trades don’t always fall our way, the market doesn’t always react as we expect, and there will be disappointments.

However, it doesn’t pay to be a pessimist, in the long-run. Fear of a trade exploding in your hands can lead to fear of executing trades.

Our trading psychology lessons have covered a lot of information already on fear, and how it can cripple your trading life.

While it is important to take a disciplined approach to the market, it’s also important to acknowledge that there will be positive trades that bring positive returns. After all, isn’t that why you’re in the market in the first place?

6. A trader looks at the market as a video game

This is a very interesting and current way of viewing the market. After all, fifty years ago there were no video games on which traders could base this mind-set. (Looking at the market as a New York Times crossword puzzle, anyone?).

Video games nowadays are extremely popular, and are increasingly becoming a large part of people’s pastimes. However, video games are pastimes in that they don’t have to be taken seriously.

The stock market engages your money, so it must be taken seriously. And while it’s fine to enjoy the process of trading (as we enjoy the process of playing video games), you have to remember that in real-life there are real results when it comes to the market. You can’t simply press the escape key and restart the trading game.

Of course, we’re not suggesting that the stock market become your sole life focus, but it is important to take it seriously.

Conclusion

Take a look at the above metaphors, and analyse whether you identify with any of them.

If you do, is this mind-set affecting your trading? Are you engaging any emotional responses to trading that trigger these mind-sets?

If you identify very closely with any of the above mind-sets, it could be time to change how you trade – and think.

Navigating the panic

Over the last century, the world has suffered through a number of financial crises and market crashes, ranging from the panic of 1929 to the 1987 crash.

With global markets stalling in the last week, investors might be forgiven for fearing that the bear market is back – or perhaps never left.

But one message should be shouted loud and clear above all the other mixed signals you’re probably hearing right now, and that is don’t panic.

In the midst of panic

Global markets have rallied strongly since March, most up around 50% from the lows.

However, the recovery remains shaky, and any sign of economic weakness is pounced upon by the bears.

In the last 24 hours, the UK, Australian and other global markets have dropped 3% or more.

The selling was precipitated by a re-emergence of credit fears, after a large state-sponsored company in Dubai requested an extension on paying back debt.

Why is there panic?

The panic settles in because people are confronted by a market situation that is far from normal. Panic in financial markets, just like panic in everyday life, is explained in psychological terms by the fight-or-flight instinct.

It looks like the flight instinct is the most prominent one when it comes to market psychology, however. The present market situation is seeing not only individual investors taking flight, but big financial institutions, too. Financial firms lose their confidence in the market, and, in a state of panic, lose their ability to transact business as usual.

But the very definition of panic is a state of irrational despair – a state whereby people or bodies act in ways that contradict reality. In its very essence, panic is therefore not a logical, or justified, state to wallow in.

That isn’t to say that the wide-spread selling occurring across global markets right now is totally irrational or panic-driven. The selling can be seen as somewhat logical, as it makes sense to move from a risky to a safe environment when the financial system looks broken, and a serious economic slowdown is on the cards.

But selling based on panic alone isn’t smart selling, and the fact is that investors who are sellers right now should be operating from a standpoint of cold, hard logic, not runaway emotion.

It’s smart to remember, too, that just because markets are behaving irrationality, this isn’t an open ticket for investors to work in the same way.

Some analysts believe that the current irrationality stems from one aspect of the market alone: from the financial sector. For instance, a large part of the nonfinancial part of the economy is strong, and statistics show that these sectors are much stronger than during the Great Depression – another time of global economic panic.

With strength still evident in some parts of the market, it is illogical to react to your entire portfolio with panic. Oh, and there’s that one significant point that panic blinds investors from seeing: that the current dismal state of affairs is not here to stay.

Wait out the storm

The good news is that financial panic doesn’t last forever. Though fight-or-flight instincts are now seemingly driving the market into the ground, the market must recover, or (brace yourself) crash first and then recover.

Either way, a recovery will come. Unfortunately, it is also a fact that recovery takes longer than a crash.

Benjamin Graham, the father of securities analysis, said all the way back in 1934 that a market crash stems from three forces: the manipulation of stocks, the lending of money to buy stocks, and excessive optimism.

When you remember the high-spirited bull market we enjoyed leading up to this crash, and the money that has changed hands in an attempt to stop this market drop, you might have to admit that Graham has a point.

Survival the key

It is true that the current situation is one of uncertainty, but behaving in an irrational manner won’t help the situation. Earnings growth has slowed and might continue to slow, but many companies still possess fantastic balance sheets, so when we come out of this crisis, we can expect pretty strong growth.

In other words: don’t follow the herd fight-or-flight mentality and jump out of the market because you’re feeling scared. Use sound advice to guide your actions. There are no easy solutions to the state of the markets right now. The issues guiding the markets at the moment have been building for decades, and won’t be solved in a day.

It’s rough at the moment, but the future will bring promise. Every generation has its own stockmarket crash, and this is ours.

And guess what? Each generation’s crash passed, and those that came out on top were those who used their heads – and didn’t panic!

Fundamental Analysis for the Technical Analyst

Most technical analysts aren’t interested in Fundamental Analysis (FA).


By ignoring some of the very useful information FA affords, traders are cutting themselves off from a potentially valuable aid to their decision-making process.

Contrary to popular belief, using FA to help you trade doesn’t have to mean spending hours poring over boring balance sheets. Quite the contrary!

There are some simple FA techniques, tips and pieces of information that even the most ardent TA follower can quickly get their hands on and benefit from.


When trading shares:

√ Reporting

It’s pretty hard for even an ardent FA follower to stay on top of, and dissect every announcement made by a company. However, it is important to pay attention to basic reporting dates. As a minimum, companies report first-half (1H) and full-year (FY) results, and these can move prices significantly.

The dates of upcoming results releases can be found in our calendar, or on listed companies’ websites. The extra volatility that can flow from these releases can be a reason to either trade or else refrain from trading, immediately before these dates.

√ Dividends

Keep an eye on ex-dividend dates. These have the potential to push shares lower, and can interfere with support lines and other technical aids. These can be found in our calendar, or on a company’s website.

√ Broker reports

A stockbroker’s view of a company can have a huge impact on its share price, and this is especially the case with smaller stocks.


√ Currencies

Currencies, especially the AUDUSD, can play a big part in a company’s fortunes. A rising AUD is good for importers, like retailers, as it makes imports cheaper to purchase (given a stronger AUD).

However, a strong AUD is bad for companies that have large international operations. This is because revenues earnt in another currency reduce in AUD terms, as the AUD strengthens.

Exporters are also hurt by a rising AUD, as this makes their products more expensive, and thus less attractive, to purchasers in other countries.

A weakening AUD has the opposite effect on these types of companies.

√ Keep an eye on commodity prices

Quite often, energy and mining stock prices will be highly correlated with oil and metals prices.

Therefore, when trading energy stocks, keep an eye on your oil charts.

Similarly, when trading mining companies, keep an eye on base metals charts.

Oil, gold and base metals prices can also be important for non-resources stocks. For example, higher oil prices will be bad for transport or airline companies.

√ Inside buying

Fund managers and company directors are often buying and selling large chunks of shares. This activity can, and does, move prices, especially the smaller stocks.



When trading indices:

√ Public Holidays

When trading equities indices, particularly overseas equities indices, you should be aware of any upcoming public holidays, as you may not be able to trade on these days.

This may leave you exposed to large adverse price movements when your market reopens for trading.

√ Major stocks going ex-dividend

When you are long an equity index, and a relatively large company within that index goes ex-dividend, you can expect to see some of the effects of the share price fall feed through to the index.

This is particularly so with capitalization-weighted indices, such as the Hang Seng, where a company like HSBC comprises a very large proportion of the index.

When trading currencies:

√ Keep an eye out for economic data

Key releases include interest-rate announcements, CPI, GDP, PPI, jobs data, confidence and manufacturing data.

These can be found in our calendar. Again, the extra volatility that can accompany these releases can be a reason to either trade or not trade immediately before the releases.

When trading commodities:

√ Focus on the US Dollar

Most commodities are priced in US dollars, so their prices are influenced by movements in USD.

For example, if the USD starts falling, it should be bullish for commodity prices such as crude oil. So when trading oil, keep an eye on the USD against the other major currencies.

By using the above checklist in addition to your TA tools, your understanding of why the markets move the way they do should improve, and this can only increase your chances of becoming a profitable trader.