Governing Dynamics of Trading

Recently, I wrote a piece that explained the importance of being aware of the psychological traps that lead to poor trading and investing decisions. What I try to focus on most in articles are the irrefutable laws and principles of supply and demand. Furthermore, I attempt to show with real trades from our students and I, how adding any derivative of this simple and straight forward concept to your decision making process is tricky and dangerous. While it can be done, the foundation of a trading decision must be in line with the laws of supply and demand. This is the only way to buy low, sell high, and sell high, buy low and keep your trading low risk and high reward.

In the Extended Learning Track (XLT – Live Trading Rooms), we make this concept the foundation of our rule based strategy. This concept and the rules to our strategy in XLT are simple; executing the strategy is the challenging part. The challenge typically lies in the traders inability to keep things simple and follow rules. The main reason traders and investors of all types have problems when it comes to speculating in markets is because they can’t keep things simple, straight forward, and reality based. As humans, we are masters of complicating everything. Also, as I have mentioned before, another human flaw is the ability for our minds to deceive us by way of illusion. 

Letting these two natural human flaws creep into the world of market speculation typically leads to losses in your account. This is why Casinos do so well. They lose many times in a day but follow a rule based strategy that ensures profits at the end of the day.

So often, traders want to add more strategies to their trading tool kit, add more indicators, more information from the latest best selling trading book, and so on, it never ends. What most people fail to see is that there are a few basic principles that don’t change. Gravity is one that comes to mind and there are a few more. At the core of any significant economic, political, scientific, social, medical, psychological or cultural theory lies a quest to understand and quantify the forces of change, action, or energy. The theories that attempt to quantify “force” that have stood the test of time date back centuries and are extremely simple. In the 1600’s, noted physicist Isaac Newton suggested in his laws of motion that an object will remain in motion until it is met with an equal or greater force. Noted economist Adam Smith suggested hundreds of years ago in his book “The Wealth of Nations” that when supply exceeds demand at a price level in a given market, price will decline. Smith and Newton didn’t create or invent the laws and principles for which they are famous. Supply, demand, motion, and the relationships therein existed long before Smith and Newton, long before humans walked the earth for that matter. What these two individuals did however is look mass, conventional perception in the face and challenge it with a reality that had been there all along. They were able to discover what no one else had because of a belief system that allowed them to open doors others never knew existed. If you notice, Newton and Smith didn’t figure out one specific issue. They had a belief system that allowed them to rather easily apply the core principles of their knowledge to a host of issues, producing answers the rest of the world still considers “ingenious”, centuries later.

Mathematician John Nash’s Nobel Prize winning idea became famous in the movie, “A Beautiful Mind.” He directly challenged a theory set forth centuries ago by Adam Smith. Smith suggested that the best outcome is derived when everyone in a group does what is best for themselves. Nash argued through simple logic and mathematics that the best outcome actually comes when everyone in a group does what is best for themselves, and the group. In the years that followed his breakthrough at Princeton, the Nash theory has been responsible for major global peace treaty negotiations, strategic corporate pricing models, and much more. While John Nash is a brilliant mind, his theory, like Newton’s and Smith’s, had been a part of life as long as man has walked the earth, actually, much longer than that. For example, let’s take a look at how Dolphins feed and behave in a group. Dolphins jump out of the water because they want to see where birds are feeding on a school of fish. When the dolphin’s spot the flock of birds feeding, they race over to that area as fast as they can to eat. What is most interesting is that the first Dolphin’s to arrive at the school of fish never eat right away. While the first few Dolphins can easily swim right into the school of fish and have their meal, they never do. Instead, they begin swimming around the school of fish to create a tight ball of fish, called a “bait ball.” As the rest of the dolphins arrive on the scene, they all swim around the bait ball to keep it nice and tight so no fish can escape. Then, one by one, the Dolphins take turns swimming through the bait ball and rather easily eat as many fish as they like. What the dolphins have been doing for millions of years is exactly what John Nash suggested not all that long ago; in a group, dolphins do what is best for themselves, and the group. As with the Newton and Smith theories, Nash simply exposed a simple reality that had been right in front of us all along.

Many other economic and scientific minds have come along over the years and presented the world with a new twist on the basic principles mentioned in this piece and have won a Nobel prize for it. However, in almost every case, within a few months of winning the Nobel, that person is proven wrong. You can’t change what can’t be changed. Certain things in the world only work one way.

Governing dynamics are governing dynamics… Were Newton and Smith really saying anything different or is the mathematical equation behind their breakthrough’s exactly the same? The supply and demand in markets is Newton’s mass and the motion is the movement of price from price levels where demand exceeds supply to price levels where supply exceeds demand. The point is that the ability to keep things real and simple can have very positive results while complicating simple realities can drain your trading and investing accounts quickly which in turn can have a big impact on your standard of living. Those who can’t keep things simple typically pay those who can in the financial world.

Hope this was helpful, have a great holiday weekend.

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