Your Destructive Mind
Stockscores.com Perspectives for the week ending January 22, 2005
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In this week's issue:
Do you consider yourself a normal human being? Are you the kind of person that does not like to feel pain, do you want to feel good as often as you can? Do you want to prosper and find the freedom that wealth allows? Do you work to avoid financial ruin? If you are a normal human being, and answer yes to these questions, then you are hindering your potential to do well in the stock market.
It is a cruel paradox that investors aspiring to make money in the market are held back simply because they have this aspiration. The mistakes that hurt the investing success of most people are behavioral, a result of our early psychological programming. While so many investors seek external solutions to their lack of stock market success, the answers often lie within.
From an early age, we are taught to avoid pain. By falling on ice, we learn how to walk when it is slippery. After touching something that is hot, we learn to be sensitive to heat. When a friend at school hurts our feelings, we learn to protect our pride.
The avoidance of emotional pain is a big problem for stock traders because success in the stock market requires that we manage risk effectively. Preventing small losses from turning in to big losses is important to longer term success. However, because we tend to be myopic in our outlook, most investors avoid taking small losses and instead hold on to their losers. These weak stocks often go lower, causing the small loss to turn in to a bigger one. It is the big losers in our portfolios that really hurt our overall performance.
Therefore, it is essential to seek out pain and take the small loss when the market tells us that our trade is not working the way we had expected. Since it is difficult to rationally decide what that stop loss point should be once we own the stock, we should determine the stop loss at the time we are considering the trade. That way, we can rationally determine our risk and identify the loss limit point.
We also learn to seek out pleasure as we grow older. Good behavior may be rewarded by a gift from our parents. Winning a sporting event or contest brings us elation, so many of us become very focused on winning. We all want to cross the finish line in first place.
The problem with stock trading is that we don't know where the finish line is. When buying a stock, we really don't know when the opportunity will have run its course and therefore, when we can declare ourselves a winner. As a result, many traders establish a finish line when they enter a trade. The promise to sell the stock when it is up 30%, or when it gets to a specific price point gives us the comfort of knowing our goal. But it hurts performance.
By establishing price targets to the upside, we are effectively limiting the upside potential of our trade. We may buy a stock at $10 and sell when it rises to our target gain of $15, telling ourselves that we can't go wrong by taking a profit. However, we have hurt our performance if that stock remains likely to still go higher and in fact rises to $25. While it felt good to lock in the profit when our price target was achieved the missed opportunity from not holding can have a dramatic effect on our longer term performance.
Instead of limiting upside we should plan to simply sell the stock when the market gives us a sell signal. When market activity indicates that a bought position is now more likely to go lower than higher, it is time to exit. We should not sell our winners because we want to feel the pleasure of locking in a profit.
Our society teaches us to desire wealth and rewards our success with things that give us pleasure. Greed is a powerful motivator that causes many people to enter the stock market without regard for their lack of knowledge or experience. There are many investors who will shrug off a $5000 loss in their portfolio but won't consider spending $2500 on an education that will teach them how to avoid such losses.
There are some traders who invest in an education but then ignore what they have learned because they focus on the dream of making money in the market instead of the rules for making money in the market. A quote from the lead character in the movie Wall Street perhaps says it best, "Never get emotional about stocks, it clouds your judgment. And if you need a friend, get a dog."
Fear of losing money is something that most people have learned to avoid because losing money when you expected to make money is such a deflating experience. The investor who fears losing is destined to make bad decisions governed by their fear. If you have taken on more risk in one trade than you are comfortable with, you will likely make a mistake in the application of your trading rules.
A winning race car driver does not worry about crashing and in the same way I have found that the very best traders are the ones that don't care about losing. By taking as much risk as you can handle without caring too much, you set yourself up for unemotional and successful decision making.
Winning in the market is possible, but the formula is not as simple as knowing when to enter a stock. The thing that separates the best traders from the rest is emotional control and discipline. Think about the psychological factors that prevent you from trading well, and then create a plan to reprogram your brain to be a powerful trader.
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Pessimism is best represented on a stock chart by falling tops. Falling tops indicate that, over time, sellers are gaining strength and buyers are losing their motivation. When stocks consolidate with falling tops, the pessimism is complemented by growing consensus on what the stock is worth. As a market comes to consensus above a support price, a potential trading opportunity takes shape.
We get a signal that the bears have taken hold of a stock when three phases have run their course.
The upward trend line has been broken
A price consolidation has evolved, preferably with a falling top signaling pessimism.
A penetration of support occurs.
A good short selling opportunity occurs when these three criteria appear, particularly on stocks that have made considerable price gains in the most recent three to six months. As traders take profits off of the table, and fear begins to build among owners of the stock, the downward momentum in the stock can increase, creating a profitable trade for the short seller that established a position on the breakdown.
I ran this scan and it produced hundreds of candidates because of the recent general market weakness. Three stocks stood out as worth considering for short sales or put option plays.
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1. ADBE
ADBE's upward trendline was broken about two weeks ago, and the stock is now flirting with a break of support at $57.50 after making a head and shoulder top pattern. I think this stock has good potential to fall into a downtrend so long as resistance at $64 is not violated. This stock is optionable.
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2. BSC
BSC is in the Investment Services sector and is breaking down through support at the same time that the sector is rolling over. I think the strong up trend in BSC may be coming to an end and we could see this stock take a fall over the next few months. This stock is optionable.
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3. SINT
SINT is a classic example of a trend reversal chart set up. The stock's up trend was broken, and the stock is now breaking down from a falling top, which is a sign of pessimism. Resistance at $29 and the likely target for support is $20.
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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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