The Psychology of Trading and Investing

Trading psychology is a subject most books and so-called professionals keep separate from the mechanics and strategies of trading and investing. A reality largely misunderstood is that the underlying mechanics and strategies within trading and investing are a direct function of your psychological belief system. At any given time in the stock market, there are buy and sell invitations sent out in the form of news events, technical indicators, earnings reports, company announcements, brokerage upgrades and downgrades, and much more. These invitations are then received by the belief systems of tens of millions of traders and investors worldwide. What separates the consistently profitable market player from everyone else is a psychological belief system that filters all these invitations to buy and sell through the market's ongoing supply (resistance) and demand (support) relationship. When this is done properly, you will quickly realize, for example, that often, a buy recommendation from a brokerage firm and/or a good earnings report from a company do not equate to market demand or higher prices for the company's stock. Conversely, negative news or a brokerage downgrade may actually lead to a low risk / high reward buying opportunity. Some of the most common and popular invitations to buy and sell occur with stocks. Providing awareness of the various buy and sell invitations for stocks, demonstrating how to mechanically filter these invitations through the stock market's true supply and demand equation, and providing rule-based tools for taking advantage of these frequent traps and opportunities is the focus of this article.

A psychological belief system that enjoys consistent low risk / high reward profits is one that identifies and accepts an invitation to buy into a market when objectively, market price is at a level where demand greatly exceeds supply. A belief system that suffers consistent poor results is one that identifies and accepts an invitation to buy into a market when objectively, price is at a level where supply exceeds demand. There are two types of buy and sell invitations. The first are the market's buy and sell invitations which are based only on the irrefutable governing dynamics of supply and demand. The second includes everything from good and bad news to positive and negative earnings reports, to brokerage upgrades and downgrades and many more. The first has you focus on reality while the second has you focus on everything but reality, and that is a trap.

US equities rally up on Yuan intervention

Mon, Jun 21 2010, 14:18 GMT

http://www.fxstreet.com

FXstreet.com (Barcelona) - US benchmark indices tracked the wide-spread positive tone seen in financial markets, as investors embarked upon a quest for higher yielding corners across the market place. The aggressive shift targeting upside levels is primarily attributed to the PBoC's vow to unpeg tight oscillations between the Renminbi and the US Dollar. The investing community rose its global outlook on the basis that the action taken by Chinese's officials will likely rise demand for exports and commodities. The Dow Jones Industrial Average logged in substantial gains through the first hour of trading as the index jumped above 1.30%. The Nasdaq Composite surged by more than 1% while the S&P 500 rose by 1.50%.

For example, China announced positive news recently regarding the unpegging of its currency as seen in the news release above. That morning, as the news came out, global stock markets like the S&P above rallied strong, gapping up as much as 1.5% on the news. The moment this "positive buying invitation" into the stock market was delivered to your belief system through your television screen or the news feed on your computer, there are two questions you can ask yourself.

First: What did the news suggest I should do? In this case, whatever the details of the news are, the release of it pushes the positive button in your brain and most people will be invited to buy.

Second: What would a consistently profitable buyer and seller of anything do at this price based on the irrefutable laws of supply and demand? When we objectively assess the market's supply and demand equation after the news was released and price gapped up, the invitation sent to the reality-based belief system is to do nothing or sell, not buy.

Notice the price action near the top of the chart. A couple of times, price is basing, sideways but can't stay at those levels and declines. The only thing that can cause the drop in price is more willing supply than demand. Therefore, when price revisits the supply level marked on the chart where the short entry was taken, we know two things: First, the buyers, at the point I shorted, are buying after a significant advance in price. Second, they are buying at a price level where supply exceeds demand. A consistently profitable buyer and seller of anything would never make these two mistakes. If they did, they would not be consistently profitable. The laws of supply and demand ensure that the buyer who buys after a period of buying, and at price levels where supply exceeds demand, will consistently lose their capital over time.

Had you taken the news event as an invitation to buy, you would have let illusion distort the reality that is always right in front of you, and losses, or drawdowns, to your hard-earned capital would have followed. Had you filtered that invitation through the laws of supply and demand, you would have been a seller like I was.

Why would that novice buyer make such an obvious mistake? Simple, the belief system that drives their behavior/action is flawed. When you understand that your psychological belief system IS your trading and/or investing strategy, you will realize how important it is to align your belief system with reality. You are essentially searching for truth so beware of illusion. The addition of even the slightest amount of illusion into your belief system ensures truth will never be found.

Often, the focus of poor trading and investing results is a lack of discipline when attempting to follow the rules of a strategy. What keeps people from not following rules is typically not a lack of discipline, it is because their invitations to buy and sell are not in line with their psychological belief system. There is internal conflict when it is time to take action. Don't punish yourself for not acting when the market calls you to action. Instead, take a step out of the box that is your belief system and make sure it is only filled with objective information and reality.

Any and all influences on price are reflected in price.

All the news and market information is filtered through your belief system. Your belief system is responsible for the thoughts and perceptions created from the news and information. Every thought and perception leads to ACTION and in trading and investing, action is either buying or selling. Therefore, all the consistently profitable trader or investor needs to focus on is price. Whatever the news and information for the stock is, your belief system MUST filter that information through a filter that quantifies the market's TRUE supply and demand relationship before a perception is created and action is taken. This will ensure you will not fall into the trap that the buyers of the S&P did. It will also allow you to profit from the many that consistently fall into that trap

Once you understand that any and all influences on price are reflected in price at the level of your belief system, you next step is to know what true supply and demand looks like on a price chart. If you're not careful on this step, illusion can again creep into the equation if you let it. If you think the conventional technical analysis definitions of support and resistance are the answer, think again. A cluster of trading activity above and below current price is not necessarily true supply and demand. There is a very unique and simple chart pattern that represents peak demand and peak supply. While the details of this are beyond the scope of this article, the chart examples I have provided should help guide the way. Once you are able to identify true supply and demand on a price chart, simply follow these two rules:

1. A negative news event, or negative stock market information, which brings price to a level of fresh demand is typically an opportunity to buy, not sell.

2. A positive news event, or positive stock market information, which brings price to a level of fresh supply is typically an opportunity to sell, not buy.

"Last night, Intel (NASDAQ: INTC) said quarterly earnings quadrupled to 43 cents per share, topping the consensus view of 38 cents per share. Revenue rose 44% to trump forecasts as technology spending has increased among consumers and corporations." - AP

Beware of good news when price is at fresh supply.

Above is a VERY positive earnings report for Intel Corp. (INTC) along with a daily chart of the stock. This picture and opportunity was identified by me and presented to Online Trading Academy graduates during a live Hour with The Pros session, April 15th, 2010. Price opened after that report, with a huge gap to the upside from the prior day's close. While the news was very real and the stock was in a strong uptrend, that equated to major losses for those who bought based on the news of the strong earnings report for INTC. How can a real positive news announcement for the company equate to such a severe drop in price for the stock? Simple, price reached a level where objectively, supply exceeded demand as seen on the chart. We know supply exceeds demand at that level because of the strong decline in price from the level to the left. When price revisits that level on the right, this is the first time price advances back to the supply level. Again, we can now say that these buyers are buying after an advance in price, and at a price level where supply exceeds demand, the two mistakes novice market speculators make.

Had you taken the good earnings news as an invitation to buy like so many did, you would have let illusion again blur the reality that was right in front of you and lost your hard-earned capital. Had you filtered that invitation to buy through the laws of supply and demand, you would have done nothing or recognized the opportunity to sell short. To be blunt, over time, the capital of those who fall for the illusion trap typically ends up in the bank accounts of those who focus on the reality of pure supply and demand in markets. The objective supply and demand relationship in markets is revealed most clearly in price and price alone.

What you perceive to be a rational decision-making process is actually your emotions reflected by a set of behavioral patterns you likely don't even know exist. The process that all humans operate under is a process whereby emotions are reflected from ingrained patterns of behavior. The buyers of INTC shares have a belief system that has them thinking they were making a rational decision to buy. As rational as it seemed to those buyers, it certainly was not logical. That rationale, again, is due to a faulty belief system that is not in line with the reality of how markets really work, nor how you profit from buying and selling anything. The reality was that INTC share prices were at extreme retail (supply) levels which means the low risk, high reward, and high probability opportunity was to sell short and profit from a downside move in the stock. Selling short at that supply level meant finding a buyer who "believed" INTC was worth buying at that level. The earnings report helped send that illusion.

How can we benefit?

BP shares fall to new low over Gulf spill – AP, Thursday June 24th, 2010

BP fell hard on the news, right into our demand zone. The reason for that demand zone is because that area is the origin of a strong rally in price. That rally only happens because demand exceeds supply in that area. In reality, price simply dropped down to deep discount wholesale prices, which is where anyone would be an interested buyer if you look at it that way. Think of it this way... You walk in the store and your favorite item is on sale for half price. Naturally, you're going to get excited and probably buy more than you typically do. Your emotions are going to drive you to buy more of this item and so on. The greatest mental edge in trading and investing is to realize that this is EXACTLY how you have to think when trading or investing. Amazingly, most people take the exact opposite action when putting their hard-earned funds at risk in the markets. This is because they are focused on the bad news from the oil spill. Don't get me wrong, that news is very real and very awful! It is truly a horrible event, but that is a separate conversation from the buying opportunity that news presented.

Below is an email from one of many Extended Learning Track (XLT) class members who took advantage of this low risk, high reward, and high probability opportunity and bought shares of BP at the demand (retail) price level. Who did he buy from? He bought from a seller who focused on the bad news as a strong invitation to sell. Whether our XLT student below is trading the markets, shopping at the grocery store, buying a car, or anything for that matter, he realizes that how you properly buy and sell things in any other part of life is EXACTLY the same as how you should be buying and selling when it comes to trading and investing.

Sam,

I sold my shares of BP yesterday @ 38.47 for a realized gain of eleven dollars. I'm doing an average of 800 a day now. I would like to personally thank you. Thanks a ton!

Mark H.

The natural invitation to buy is completely inversely related to how you make money buying and selling anything. It is certainly not in alignment with supply and demand. Most people, however, are not naturally invited to buy when the objective low risk / high reward buying opportunity is in front of their face. As you can see in this last example, PRICE MUST DECLINE in order for it to reach an objective fresh demand level. The vast majority of people are only comfortable buying after a period of rising prices, not declining prices. Also, most people are not comfortable buying when the news is bad. Remember, pretty green candles, uptrends, and good news rarely if ever bring price down to price levels where demand exceeds supply. This is all quite ironic if you think about it because if you take your average trader or investor out of the market environment, they act almost opposite when buying and selling anything else. For example, when we go and buy a car, we try and get the best deal we can. The astute car shopper finds a car and knows what price he or she is willing to pay and attempts to get that price. If that dealership is not willing to drop the price to the desired price of the buyer, that potential buyer typically goes from dealership to dealership to find someone willing to sell the car at the lower price. In trading and investing, however, people for some reason wait for good news and higher prices before deciding to buy; this makes absolutely no logical sense if your goal is to buy low and sell at a higher price. It is completely inversely related to how we profit when buying and selling anything.

Whether you trade or invest in stocks, bonds, futures, currencies, options, or anything else, how you profit in these markets and how you quantify supply and demand never changes. Furthermore, a trading and investing strategy that works is one that is not market-specific or time-period-specific. The strategy that offers consistent low risk returns is one that mechanically filters the vast amount of illusion creating information by objectively quantifying fresh supply and demand in any market and at any period in time. Don't let the shadow of illusion distort the reality of a governing dynamic that is always right in front of you.

The good news is that you already have a belief system inside you that knows how to properly trade and invest in markets. You use it every day at the grocery store, appliance store, car dealership, and so on. Think about how you operate when buying and selling anything in your life outside of the trading and investing markets. You try to get deals and buy things as cheap as you can. The key is to now use this exact same belief system to make decisions in the trading and investing markets. If you happen to be someone who actually cuts coupons, you have a belief system capable of producing above average returns as a trader or investor. I think you get the point.