Mind the Mind
Stockscores.com Perspectives for the week ending September 9, 2005
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University of Calgary Murray Fraser Hall 164
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October
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In this week's issue:
Successful trading of the stock market is not about understanding the inner workings of the financial world. True, that is what the mutual funds and academics would like you to believe. The book writers want you to believe in their knowledge too. The media emphasizes the importance of financial theory and company fundamentals. It seems to me that a lot of effort is made to complicate what the stock market is really about. Perhaps that is how the financial industry maintains their advantage over the retail investor.
But the average person on the street knows a lot more about the stock market than they think.
Do you understand your moods? Do you know when you are scared or when you are elated? Have you ever been hurt because you did something risky?
Human behavior and its understanding is essential to predicting changes in stock price. As investors, we all want to buy stocks before they go up and sell stocks before they go down. True, the fundamentals of business drive the gyrations in price. But they are comparable to the experiences of life that drive our state of mind.
While it may seem overly simplistic, think of stocks in up trends like people in good moods. How do you get in a good mood? You are influenced by your surroundings, the people you interact with and the experiences you gather. Your mood can be pressed in to happiness by a collective of these events or by one incredible event that surprises your consciousness and exceeds your greatest expectations.
The same can be said for stocks.
Once happy, it takes time to bring your mood down. Your happiness has momentum and can only be dissuaded when a series of negative events reverse its course or when your expectations become so ebullient that meeting them is no longer possible. Like a stock's trend, your state of mind cycles over time.
The more I watch stocks the more I realize that they behave like people. Some are volatile, some are steady and confident. Some are depressed and others are exceedingly happy. Throughout the years I have seen a fair share of stocks that are entirely phony.
So why do I draw this metaphorical comparison between stocks and people? Because I want you to make money. I want you to understand that knowing the difference between a quick and current ratio is not important. Understanding how to use the MACD indicator will not make you rich. Recognizing an ascending triangle pattern will not give you direction to the money machine.
To make money in the market, you have to understand human psychology and stay one step ahead of the normal person's next mood.
Toward this pursuit, you need not be well versed in Freud or the texts of behavioral science for you have yourself to stuffy. You only need to lower your own inhibitions against self examination. Understand your feelings and those of your peers and use that to predict what the crowd will do next.
I know how my normal human emotions make me feel when a stock is going up quickly. I know how I feel when a stock I own is rapidly plummeting. I also know that to be successful I have to maintain an abnormal response to these emotions. To be ahead of the crowd I need to understand how they think but then choose to think differently. Two or three steps ahead of the masses will make me money.
Go through some stocks charts of stocks that you have owned and try to recall the emotions you felt at different times along that chart. You feelings may have misguided your actions and hindered your from trading for the maximum profit. What if you had ignored your current emotion and thought about what your next emotion will be?
For example, suppose you own a stock that is making you a nice profit. Then it starts to fall. If you are like most people, you will feel some fear but also some resolve in holding on to your position because you hope it will go back up to its recent highs. As the stock falls further your fear will grow until you are motivated by that fear to sell your stock. Then the stock will bounce back and you will regret selling, wishing instead that you had stock to your resolve in the quality of the position. If only you had thought one step ahead.
Important events in a company's history are difficult to predict but the reaction the market has to them seem to repeat over and over. How human beings react to fear and greed is predictable. Most of us want to pursue pleasure and avoid pain and have a myopic outlook of our experiences. Understanding that the crowd is the same way can allow you to make money from there predictable gyrations.
When considering a stock, always ask yourself, "What is the crowd thinking right now?" Then ask, "What will they be thinking next?" Trade on what they will be thinking next.
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Companies that announce major news after the close of trading will often gap up in price the following day. An upward price gap occurs when the low of the current trading day is higher than the previous day's high. This abnormal price activity is useful because it indicates that the stock is trading more on its own story and less on the general movements of the market.
The Gap Ups strategy seeks stocks that are gapping upward on abnormal volume from low price volatility. Adding in these extra criteria improves the probability of picking a stock that is likely to go in to an up trend in the future. By focusing on stocks with low price volatility before the gap, we focus on stocks that were truly surprised by whatever motivated the price gap. Since the market's psychology is shaped by the past performance of the stock, price gaps tend to influence the market's mood favorably, and create optimism. This optimism can lead to a further price appreciation.
However, stocks that gap up often have to take a rest before they try to go in to an up trend. The sudden move to the upside is met with selling pressure as some investors happily sell at a profit, without regard for where the stock may be going in the future. When faced with fast money, many investors take their profit and run.
Therefore, it is often better to wait for entry in to a stock that gaps up in price. After the gap up, patience for a subsequent close above the gap day high can improve the probability of success again. Of course, having this patience can also mean paying a higher price, or being left without a position in a strong stock.
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1. WLV
The WLV chart shows a cup and handle pattern at the end of a downtrend, and looks like a stock that is likely to reverse course and head higher in the weeks to come. We may see the stock stall at the $11 and then $12 resistance levels but that is decent reward potential considering support is at about $6.95.
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References
Get the Stockscore on any of over 20,000 North American stocks.
Background on the theories used by Stockscores.
Strategies that can help you find new opportunities.
Scan the market using extensive filter criteria.
Build a portfolio of stocks and view a slide show of their charts.
See which sectors are leading the market, and their components.
Disclaimer
This is not an investment advisory, and should not be used to make
investment decisions. Information in Stockscores Perspectives is often
opinionated and should be considered for information purposes only. No
stock exchange anywhere has approved or disapproved of the information
contained herein. There is no express or implied solicitation to buy or
sell securities. The writers and editors of Perspectives may have positions
in the stocks discussed above and may trade in the stocks mentioned. Don't
consider buying or selling any stock without conducting your own due diligence.
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