Turning Points: how trends are born and how they die

There are a lot of lessons to be derived from the recent market events. In this post I want to focus on two that have to do with identifying turning points. At the risk of making post too long, I'll put them together since they are very interconnected.

Turning points are in effect change of the trend. Thus, it's important to look into what maintains trends and what causes them to end.

Lesson 1. What causes trends to end, or pendulum effect.
System when pushed hard and far enough, pushes back. The harder and farther has it been pushed, the harder and farther does it push back.
This concept is well described and explained in a brilliant book The Fifth Discipline: The Art & Practice of The Learning Organization .
We all witnessed how, during oil stunning rally, all kinds of higher and higher targets were assigned - 150, 200, 300. Part of those predictions that is related to what we discuss is this: there were explanations to those targets and to continuing rise of the price, that cited all kinds of equations, how much oil is out there and can be extracted per day, and how much oil per day is consumpted and needed. Projection of the growth in both parts of equation led to a conclusion that supply and demand ratio will inevitably cause further price rise. Were those equations correct? Sure - if you accept the fact that system will not push back. But it will (and it did) - in a form of slowed down consumption (caused in no small part by the very cause of imbalance in the system, fast and hard oil price rise), in a form of developing other energy sources (yet to materialize to really meaningful degree). Similar predictions put food prices above the clouds, and failed in a similar fashion. Similarly, rapid increase of predators in a certain area eliminates their very food base and leads to banace restoration when predators start dying of starvation. Similarly, explosive expansion of a particular company often undermines its growth perspectives and requires contraction to regroup and find the way to evolve in a more mature fashion. Similarly, overheating of a certain area covered with water leads to increased evaporation and forming of clouds that cool the area off. Finally, to return to the markets, similarly excess of buying leads to exhaustion of buyers and eventual trend reversal. Similiarly, abundance of short positions leads to short squeezes. This phenomenon is known as "becoming a victim of own success". It's also known as reversion to the mean. Nothing exists in vacuum - everything is a part of the bigger system, and when a certain element of the system gets out of balance, there will be parts of the system that push for balance restoration. Thus trends are being born when a certain element upsets the system, and trends reverse when system pushes back.

Lesson 2. What maintains trends, or inertia effect.
Markets tend to overshoot any reasonable targets on both sides.
This phenomenon is well known as well, but somehow rarely taken into account at the time. When oil started showing signs of cooling off and reversal, very few people called for such seemingly far away (at the time) targets as 80 and below. When NASDAQ started running in 1998, no one could even think of such heights as 5000 - and similarly, when it reversed in the spring of 2000, no one could imagine that it could drop as low as it did. "Market can stay irrational longer than you can stay solvent" - sounds familiar in light of recent events even to those who never heard this sentence, doesn't it? If you want to see the most recent example of this, look no futher than at intraday chart of UAUA for two days, Oct 16 and 17. It would reach all reasonable targets, and still continued to go to unreasonable, and then some more, and then a lot more. This phenomenon takes care (which in market terms means deprives of profits or causes losses - cynical, I know) of those who trade on "obvious" as they see the obvious - which is usually how the majority sees it. "Deprives of profits" part is materialized when profits are being taken where reasonable targets are reached - and market advances well beyond reasonable, leaving those who took their profits in the dust. "Causes losses" part is materialized when countertrend position is being initiated at reasonable targets (shorting oil on the way up at 80? 90? 110? Going long on thwe way down at 120? 100?), and market overshoots those targets and stays "insane" long enough to cause desperation or margin calls.

Failure to take into account and to balance against each other both of these principles leads to severe misreading of the market. Try to analyse what caused billion-sized losses in Pickens energy fund, and you will see how this works. Having made immense amounts of money in oil, where such mis-calculations came from? From misreading the system as a whole first, thus believing in endless price rise? From underestimating the inertia on the downside move, thus multiple calls (and according actions or luck of such) of "oil will never lose $100" kind? You will see numerous examples of miscalculations of this kind in analysis and trades of many around you, and possibly in your own. Hopefully, this overview will help you recognize the fallacies in thinking and balance these counteracting principles in the future.

Information - Price Divergence

This is one of the most reliable indicators helping you discern the market's intentions. Some theory first, not too much, I promise... rather like a brief refresher. Market is a discounting machine, meaning tomorrow's development is being factored in by today's price action. That's why one who acts on known information is always late - when information is known to everyone, it's being already acted on, and late arrivals will be taken advantage of. As an example, think of upgrades and downgrades issued AFTER a major price movements or earnings announcements. Price action is an ultimate truth in the market - and it means that if there is a divergence between what a price is supposed to do based on available information, and what price does in reality - it's a price action that you need to go with. More than that, such divergence serves as a very powerful indicator for you, because it shows you that at this junction Smart Money clashes with Crowd. Crowd goes with obvious - with what information says. Smart Money meanwhile takes contrarian position. This is an ultimate case of "Trade what you see, not what you think".

Now, let's use fresh example as practical illustration of the principle. Yesterday, while the markets were preparing to a 700B rescue bill vote (you can read a whole transcript of our trading session in trading logs, Oct 3), I was asked:

[11:48] {member} so..whats your thoughts after passage on mkt for the day?

Here is the answer:
[11:49] {Threei} seems like selloff in cards... with or without initial short-lived spike

... and follow-up comment:
[12:10] bill passage is now all but sure, yet market doesn't really running
[12:10] makes you think...
[12:11] that dump may be an outcome in any case

Indeed, this is exactly what happened: immediately after bull passage market dropped fast and hard. Let's see how I arrived to that conclusion (which naturally kept us out of long trades at the moment of House vote). When a project of this bill was first announced, market rallied for two days. When a bill was brought for a vote first time and rejected, market dropped 700 points. Natural conclusion is, market likes the bill and will go up when it passes the House. So, day of the vote comes, comments clearly show that the bill is going to pass, yet we see failry lackadaisical, if I may say so, movement. Market is positive but there is no serious upward pressure, no boiling, no bruning desire to buy everything in sight. That's your Information - Price divergence. Information says: bill will pass, market likes the bill, it's a long. Price says: beg to differ. You saw what happened next. Price always wins, and a trader makes money by being right on price, not on information.

Non-stop Discussion of... Stops

No matter how much I write about stops, this topic doesn't seem to go away. Like Phoenix from ashes, time and again it arises. Recent discussion with a long-term trader returned me to this endless source of questions, doubts, hopes and frustrations.

Warning for overly sensitive types. The text below may seem harsh. Consider it tough love. My counterpart in this discussion took it this way and, I am sure, stands to benefit from it.

The story is probably all too familiar. A good trader in all other regards, knowledgeable about both fundamental and technical sides of trading, capable of picking right sectors and stocks, determining the direction and timing his entries. Beautiful performance on winning trades. Overall performance, ummm... leaves to desire. Threading water at best, losing money is more like it. Why? You probably guessed it. Some of misses are so disastrously big that they manage to negate all the wins and add some red on top.

I think I'll never understand why traders so stubbornly refuse to take stops. No, I was not born with this skill ingrained or inherited. I had my share of blown stops in early years, and they cost me dearly. But but but... how many times the same lesson needs to be taught before we finally heed it?

Here is why I don't understand it. Are you, a trader who doesn't want to take stops, compete for the title of Da Best Trader of All Times and Nations? Because if you manage never ever to lose, you sure are going to be one. No trader in history avoided losses. Not one, period. Whoever your trading idol is, be it Jesse Livermore or the guy who taught you how to click Buy button (hint: GENTLY), did he win all of his trades? No matter how skillful you are, you will lose on some of them simply because of market's nature. Uncertainty Thy Name O Market. It works in odds, not in certainties - meaning, even the best of setups and flawless trades executed according to those setups will fail sometimes. Now, if you acknowledge this (and if you don't, you have no business to be trading), why not limit your losses? This is exactly what stop loss does - according to its very name it STOPS YOUR LOSSES.

Let me say this... the question above is rhetoric one. I know why you refuse to do it. I already wrote about it in the past at
here (and discussed how to place them in two articles before that). One aspect of this, however, I want to return to. This aspect is RANDOM REINFORCEMENT. It means that not every time a market is going to reward you for doing the right thing or punish you for doing wrong one. Sometimes a stock you just took a stop on will rebound right away. Sometimes a stock you held against all rules will reward you for breaking the rules. Each such case will lead you into temptation to abandon your discipline. "Just this time, please, and I promise to be good again" Nope. Won't happen. You will be bad again, because being bad was rewarded. This great temptation by the market is like siren song - never what it seems to be yet who of us can resist.

Cure is simple. Run the stats. Calculate the total of all losses that got out of hand. Calculate the total of all the losses taken according to the rules - when the stop was hit that is. See what those stocks did after you got out - rebounded? Died on the vine? calculate where your portfolio total would have been should you take all the stops in disciplined manner. Calculate the same fior the case where you would have refused to take any stops. You got your answer.

Me - I take any stop whenever it's hit and consider it my salvation. Foe stop to me is not.

Lost and Found, or Does Common Sense Work in Trading?

There are things in trading that run contrary to common sense as we know it. Recent conversation with a trader who asked for advice is a good example of such occurence and illustrates often-made mistake.

First, a joke showing what common sense leads us to do. Fair warning: joke is silly and decisively not funny. A drunk crawls under the street light looking for something on the ground. Asked what he is looking for he says "Lost my watch on that corner". Asked why he is looking here when a watch is dropped 15 yards from the spot, he explains "It's dark over there, little chance to find anything, so I am looking here where there is a street light".

... OK, I warned it was lacking in laughter department. Nonetheless, it indicates that looking for a lost thing in a well-lit spot instead of where the loss has occured is silly. Now, let's get back to our trader and his question.

- I have this pattern of suffering a string losses... it starts usually when I get onto some very volatile stock or a stock making unusually big movement, looking so lucrative because of a great potential. So I jump in, it moves against me, I take quite a loss. Next thing I know, I make trade after trade on this same stock. It's like I got addicted to it and just can't move onto something else. Loss after loss, the day turns into total disaster. Got something to hit me with to cure this disease?

- Got a question for you. Why continue trading that same stock after couple tries proved unsuccessful? Why not leave it be and move to something ou have firmer grip on?

- Well... it makes big movements, I have better chance to get back all those unusually big losses...

- But you don't have reliable read on this particular one. Isn't it more likely that you will suffer more "unusually big losses"?

- Ummmm. I don't know. I just feel it's natural to stay with it until I get my money back. Hasn't happened yet, even once.

That's when I remembered that joke. It's a common sense and natural thing to do in every day's life to look for a lost something at the spot where you lost it. In trading, not so much. Go to well-lit spot and look to get your money back there. Lost money is not tied to a particular spot (stock), it's lost in the market. The market is a big space; go where there is a streetlight that helps you read things well. A stock that you have no read on is to be left alone. You have no personal relationship with it, you don't need to get revenge; it has no idea about you and it's not after you. Free yourself from things that don't work. Focus on what does.

Scan for Your Battles

At the beginnning of March I opined that under certain conditions we were going to see market rally to 13000 DOW and 2000 NQ. Now that those targets and I suggested liquidating long positions, are hit a few e-mails asked whether I see this moment as a short opportunity. My negative response caused feedback along the lines "If no long anymore, then why not short?"

Here is how I approach this. There is no such thing as continuous read on the market or particular stock for me. In other words, I don't have a clear idea what to do all the time. Sometimes there is a recognizable situation, and that's where I take action by initiating a new trade. Sometimes there is nothing recognizable, and I sit on a sideline or liquidate existing position - not because I see the tide turning but simple because I have no read anymore. Thus, the reason for exit can be "I read the move as exhausted" or "I can't read this move anymore". In a former case, yes, I may start hunting for an entry on the opposite side. In a latter case - no, I exit original position but do not look for an opposite direction trade yet.

All above has a broader implication for my trading approach. My process of hunting for a trade is entirely based on an idea of having my favorite setups and waiting until such setup shapes up and triggers an alert for me. I don't watch particular stock and hunt for an entry - rather I wait for whatever matches my entry criteria. View it as casting the net with certain mesh size and reviewing whatever got caught in there. Such net for me is a scanner which I have configured accordingly to my criteria and which scans the market constantly looking for what I asked it to. Covering NYSE, NASDAQ, AMEX, TSX, TSX Venture, OTCBB, Pink Sheets and indices and being easily customizable for any thinkable trading approach, it's all the search tool I need. There are three things though it doesn't have: no dartboard, no tea leaves and no "scan for winning trades only" setting.

Such approach can be construed as one of cases of "let the market come to you". Usually it's applied in a sense of waiting for certain price treshold where you render entry most favorable. This is just another way to apply this idea.

A Trader's Job

As it happened before, during some unusual market events and/or very jittery market action I get more visits and discussions from somewhat different sandbox - long term traders. I mean, normally they won't even give a second look to my measly 30 cents here, 60 cents there profts... OK, just kidding. Either current market events drive them, at least for the time being, to shorter time frame, or something they read in Techniques of Tape Reading stuck in memory and resonated with what they encounter now... interesting thing though is, they usually come to seek a change of a timeframe they operate in but what they find is a necessity to change their philosophy - no matter whether they look at 1 min chart or monthly one.

Anyway, there was this lengthy conversation over a course of several days which, with kind permission of my collocutor, I will cite here in as short form as possible. My remarks are in blue.

- So, here is a problem I run into. At the beginning of March I took massive short position based on negative read on the economy, on financial crisis etc, you know what headlines say for quite a while. Now, things don't really seem to be improving in general economy, so I know my read on it is right. The market action, however, is totally different story. For a week or so it seemed to be rewarding my entry - and it did nothing but go against it ever since. Now I am sitting on a massive loss, market just won't let go, and I just can't bring myself to take the loss - after all I AM right! banking crisis is far from being over, economy is in crapper, etc etc. Now, I did read your post and the follow-up on this topic and understand the concept of "too obvious" but still... shouldn't common sense prevail? How can I be punished that severely for being right? What am I doing wrong?

- You are talking about being right about economy state. What you are trying to profit from, however, is the market movement. You are coming from assumption that market must reflect the economy. While connection is there, it's not that straightforward. Ultimately, you are running into divergence between map and territory. Your read on the economy is a map. Market you are trying to play is a territory. If you see the differencies, will you insist on a map being right and a territory wrong?

- No, of course not but isn't such drastic divergence a sign of manipulation?

- It very well could be, and probably is. You can call it manipulation, you can call it market discounting the future, or come up with more explanations for this action. The important thing is though: whatever definition you chose, what does it lead you to?

- Explain this please.

- See, you can throw your arms up in desperation and say "this market is manipulated, it's impossible to make money in it". Or, you can view it as opportunity. Think of it this way: when you have this divergence between available information and price action, this is great trading opportunity. Market moving against the obvious is the one delivering maximum possible pain to as many participants as possible. Isn't it exactly the situation where Smart Money take advantage of the Crowd? That same situation that creates the very foundation of Tape Reading principles? Nothing particularly new about it either - I can list quite a few books describing just this.

- Come on... I just can't see this rally as real.

- What do you mean "real"? It happened, didn't it? I have a chart to prove it. You must be thinking of how sustainable it is when you say "real" - now, that's another matter and is a subject of continuous read of the market action. So far it's bullish in one timeframe, still bearish in another - and both of those are right until they aren't.

Now, when I ask what your definition leads you to, I want to make one more distinction. Don't ever forget what your job as a trader is. Your job is to make money, not to lose it. If it's a market direction that makes you money, give it priority over your fundamental read.

- OK, not to beat a dead horse, but just one more question on this. Obviously, as far as market direction is concerned, I've been wrong so far and the pain is serious. Was there anything to tell me it was coming?

- Have a look at this chart. First, double bottom came. Then it got confirmed by the break of the top between those bottoms. That was your first warning sign. Then inverted Head and Shoulders was formed. Then it got confirmed by retest of the right shoulder line and bounce off of it. Second alarm bell... Then major resistance at 1900 got broken. And notice, all this happens while all the headlines are still total doom and gloom! If that is not a writing on the wall...

- So, when does it end?

- I think you already know. It ends when majority of participants decides that the worst is really over and that they are missing on a bullish run. They jump on a rally bandwagon, start chasing it with no regard to the price... and get trapped by market reversal. Oh, and by the way - all this will happen with choire of cheerleading media justifying the bullish case.

- This is wicked...

- This is market...

- This isn't right.

- What is your job as a trader?

- Right... You know, I just realized one fascinating thing. I repeated these slogans so often, like "Don't argue with market", "Market is always right", "Don't fight the tape"... and I thought I internalized them, made them my mottos. Yet when it came to this situation, I found myself breaking all of them. I tried to outstubborn the market, outsmart it. If I got stopped out and waited for better entry, I would be totally fine. But no, I had to decide I was right and market was wrong... Got emotionally attached to my opinion, married to my position. Let my ego take over.

- All I can add is one more motto for you. My favorite. Trade what you see, not what you think. When you see markert action contradicting your thinking, chose territory over the map. Give a priority to a market action over your trading idea.

- This is hard.

- This is liberating... and, isn't the hardest thing to do usually exactly the right thing to do?

Trading Psychology - Stage 4. Through the Looking-Glass

... and What Alice Found There.

This last stage of a trader's development in psychology department is fairly simple to understand, maybe not very easy to implement... but give it due recognition and make an attempt, and it will happen with not much effort - as long as you are ready for this transition.

The idea is really simple. There are emotions that, at your early stages, plague your trading and cause erroneous entries and exits. Those are the same emotions that cause the crowd's mistakes. As you learn to deal with your emotions, take control over them and diminish, then eliminate, their impact on your trading decisions, you don't completely eliminate emotions themselves. You just learn to dull them and separate your trading actions from what your emotions try to push you to. However, you still should be able to observe them as detached cold-blooded observer, This is a stage where you gain an ability to actually utilize them instead of being their slave. If you can feel how huge selloff creates this feeling of panic somewhere deep in you, this is what crowd feels. Feel the temptation to buy this parabolic upward spike, seemingly unstoppable? Chances are, at the moment when you feel the strongest urge to give up and just buy, that's when the last buyers desperate not to miss the train hit their Buy at Market buttons.

You see the point now. Use this as a mirror, as your window into understanding how crowd acts. Together with your strict self-control, such approach will put you on the right side of trades - and as we know from Tape Reading principles, right side is usually not the crowd's side. It's not a stand-alone method of trading of course but it's a good supplement to your tape/chart reading skills. Overall, this approach is in perfect alignment with a few Taoist principles described in our A Taoist Trader course

Two fair warnings. First, do not try to implement this element into your trading too soon. You really need to be at Stage 3 and get steady and confident at it before you try to move to Stage 4. No jumping over steps. Contrarian approach of this kind requires a lot of experience and perfect self-control.

Second, somewhat humorous... as you progress, you may find that you stop experiencing those crowd-like emotons altogether and your impulses are fully in line with your own reading now. When it happens, your attempt to read YOUR impulses as a window in CROWD's impulses may backfire as you start trading as a contrarian to yourself rather than crowd, eseentially becoming a part of a crowd again. OK, that was half-joke.

Trading Psychology - Stage 3. Clarity

Finally. Painful process of hatching is over, and a trader is born. You are no longer a slave of your emotions, you are your own person. You are in full control of your own actions. You don't jump in the middle of action or out of it on a whim - rather you are capable of pausing and weighing your options and making your decisions in a cold blood. You can see the crowd's emotions on a chart clearly, and you are no longer a part of that crowd nor you are affected by their emotions. You can evaluate those emotions and utilize them. This is an amazing state of clarity, and it's very liberating. These two words (clarity and liberation) probably constitute the essence of this stage of a trader's development. Ability to see clearly the reality of what happens and the freedom of making your own choices as to how to react - this is what makes you a master of your trading vs. being part of the crowd.

You are but detached observer of the market, never involved emotionally yet constantly evaluating the emotions of other participants, waiting patiently for the moment when the opportunity presents itself and the odds are the most favorable; entrenching yourself where you anticipate the action to unfold; pouncing when the right moment comes; having no problem to retreat if proven wrong; having no emotional baggage over any outcome and ready to act again.

All above is the description of this stage and how it feels. Let's talk a bit of how you arrive to it. The transition from stage 2 to stage 3 is not a single moment of epiphany. It's a gradual process of many small clicks, each being another piece of the puzzle falling in its place. Realization of how market's logic is different from conventional Aristotle type of logic - click. Understanding how Smart Money acts vs. how Crowd acts - click. Understanding how a chart reflects emotions - click. Realization that you don't have to participate in any market event and are free to choose your battles - click. Each click comes as a result of another lesson taught by the market - and a good teacher it is for rarely does it miss a chance to put you through another lecture or test. If you are an avid student of the market, you will listen carefully and take notes, collecting knowledge and experience. Ore comes in, steel comes out. This process takes time but it's so worth it, as all the sinter is being discarded and the final result is extremely rewarding - Clarity and Liberation.

A little sidenote is in order: when you arrive at this point in your trading career, you find out that this whole transformation has changed you not only as a trader - it changed you as a person, reflecting in other aspects of your life, making you more disciplined and in control of yourself, giving you the clarity in seeing "behind-the-curtain" happenings, better understanding people and events around you, better ability to deal with them. This comes as a side effect and is an icing on a cake... or maybe it's an ultimate achievement in and of itself, and better trading performance is merely a side effect?

Now, all above sounds so good, I just have to throw a spoon of tar in all that honey. The bad news is, this state of mind once being achieved is not necessary going to stay with you once and for all. Now and then you are going to have unpleasant lapses of sanity when old habits seem to return. We touched on this earlier in this post. The process of kicking nasty habits is not a single event, it's a process. There are sound reasons for those temporary setbacks. When we succeed we tend to stop doing what made us success in a first place. Complacency, letting your guard down, overconfidence, feeling that we became so good rules don't apply to us anymore... However, as frustrating as it can be, there is a good news, too. As you move along, overcoming another drawback and returning to the right path, your skill of dealing with this phenomenon becomes better. Relapses become less frequent, you learn to recognize them sooner and eliminate them faster and easier. They will finally stop altogether when the right way to act in the markets becomes your second nature. Or first.

So, is this all there is to the stages of psychological transformation from the sheep to be slaughtered to the money extractor, aka trader? Almost... there is just one little twist left, and that twist will constitute stage 4. Next post will go over it and conclude this mini-series on trading psychology.

For how long can you afford being wrong?

Response to the previous post warrants one more dip in the topic before I go back and finish Psychology 101 series. While the concept of "being right on the reasoning doesn't mean being right on the direction" is accepted by all who wrote back to me, one more issue has rise in discussion. The question is, since price is bound to go where it belongs sooner or later, why not just close one's eyes and let "them" play their games? Wait it out, however stomach-churning the process is, and greet the return of fairness and common sense with victorious throaty laughter?

It's surely tempting. Idea of closed eyes appeals to anyone who experienced the phenomenon of the market kicking one's butt for doing the most sensible well thought through and reasonable thing. The problem with this approach is this:

The market can stay irrational much longer than you can stay solvent.

I don't remember who said that but boy, was he right. I will go down the memory lane for one of the most remarkable examples, to illustrate just how powerful contra-obvious movement can be. I already talked about it as one of my prominent lessons (learned the hardest way, too) - those of you who got Techniques of Tape Reading (TTR) can open page 21. For those who for some incomprehensible reason still haven't read it, reminder of how the story went.

K-Tel, NASDAQ symbol at the time KTEL, little company with tiny float, announced that it was going to sell the albums with music of 60-70 over the Internet. Fine, who cares, right? Wrong. It was the beginning of Internet era. Netscape already went into stratosphere. K-Tel became a symbol of a new way of doing things. E-commerce was a new word. And a new world - as usual, brave one. Stock shot up from under 5 to over 20 in a couple days. Warranted? Heck no. Fundamentals were laughable. Perspectives were bleak. No one believed this move could mean much for the company's bottom line. So, every sensible trader on the planet, and I suspect some for Mars, went ahead and shorted it. Stock danced a bit around 20, then slowly moved closer to 30 (those were fractions times, they moved easier than under decimal system these days). Next morning it opened at 31 and proceeded higher. Then brokers called shorts in, to the horror or those who decided to close their eyes. If you don't remember those days or haven't read TTR, try to guess where the stock finally topped out? Eighty dollars!

Now, even if not for shorts being called in, would you be able to sit out such ride? I highly doubt it (unless you ARE from Mars that is). Chances are, you would have given up long before it was over, and the closer to the top your capitulation occured the more insulting it would have been. Worse yet: let's suppose blue-eyed miracle happened and against all odds you did manage to sit tight through this experience (nothing short of being made to watch Inconvinient Truth five times a day two weeks in a row). Do you think you would be able to profit from subsequent price drop? I wager Victoria, biggest crater on Mars , that as soon as KTEL dropped closer to $20 making you even, you would have covered your short with sigh of relief loud enough to be heard from that same crater. And if I am right about this, then all this horrible risk and gut-wrenching experience was for what, to get out about flat? Give or take couple millions nerve cells?

Oh, and for the irony... K-Tel's CEO, when interviewed those days, said he was not selling his shares because "he was told stock goes to 100". Now that KTEL is long gone, I wonder... if that's what happened and he never sold, was it an ultimate case of market killing both sides or what?

"History teaches us..."

As you know, I don't commment on current market conditions on this blog. Being an educational blog, it's simply not the purpose. Being that, it would also be a crime not to comment on immense learning opportunity provided by the market conditions we are seeing.

Make no mistake, we are going through the crisis of historic proportions. It's almost time to start coining a name for it. Great Liquidity Crisis? Credit Crunch of the Century? The Day (insert bank name) Fell? If you as a trader went through this market unharmed - good job protecting your behind while sharks circle around. If you make money in this market - congratulations, you do not belong to majority anymore. If you are a newer trader just starting your quest - consider yourself very lucky. Yes, lucky, because if you learn in this environment - you will find the "normal" market to be piece of cake to trade in.

Let us outline the lessons to be learned during such extreme times.

First and foremost, and the most important:
1. Logic of underlying events vs. logic of market movement.
This is one of the most confusing aspects of the market for many investors and inexperienced traders. We are conditioned to see causes and outcomes as being linked in a logical fashion. Bad news should send the price down. Good news should cause rallies. We want to buy good news and short bad news. We want to trust our analysis and act on our conclusions - and we, naturally, expect the market to follow. So, shouldn't we feel perplexed seeing how the market stages stunning rally when there is nothing but doom and gloom in all the sources of information? What else can we do but dismiss it as manipulation?

Well, manipulation it is in many cases. However, this notion doesn't take us anywhere as far as money-making is concerned. The major lesson in this is old as the market itself: if something is exceedingly obvious, the market will act against it. Market by its very nature cannot reward the obvious with money - simply because majority follows the obvious, and majority cannot be profitable. It can't because there is no pool of money set aside for the winner - money is being extracted from other market participants. Who could majority extract the money from? And, if there is no money for a group betting on certain direction, then this group in fact renders this direction as wrong by simply being too big.

If this sounds confusing, let's put it in simpler terms. If there are just 10 participants in the market and 9 out of 10 bet on downward move, who is left to sell more and push the price lower? They all sold short already, so what are they going to do when they see that the price is not dropping anymore? What other choice do they have but to start closing their short positions, pushing the price higher? That single player that took long position against those 9 may be wrong about the events in economy - but he will be right on the market direction. He will make money by betting against majority. Of course this is simplified way to look at things, the reality is much more complex, with all the different timeframes, new participants jumping in or getting out. This simple case, however, explains the divergence between the logic of the market movement and the logic of economy events.

This is the major lesson of this market because rarely can it be seen as clearly as these days. Do not fall into the trap of obviousness. Being right in a long run will not protect you from the losses today. Being right about the meaning on events does not mean the market hasn't priced those events in yet. Alternatively, market may be preparing to move in your direction, and its way of preparation is to shake out prematurely taken positions. Market is doing its best to move having as few participants on board as possible - and it's doing it by means of moving against the obvious. Price action overrides everything. We traders profit from price changes - that's the ultimate market language. This divergence is your friend, not your foe - it allows you to distinguish the Smart Money action from the Crowd actions and position yourself on the right side. This is major difference between the way traders think and the rest of population think.

2. Handling extreme volaitity.

If you are a short-term trader, imagine being an investor at the times when major indices swing as wide as they do these days. 400 points range is almost a new norm for Dow. NASDAQ rallying 40 points in a matter of minutes after talking head on CNBC mentions a rumor? Gut-wrenching... How do you control your risk under such circumstances, challenging even for a day trader?

- keep your position size reasonably smaller than usual
- shorten your holding period to limit your exposure and minimize your chance to get caught into sudden move; book your profits. These are the times when investors go to swing trading; swing taders go to day trading; day traders go to scalping; scalpers.... umm, scalpers remain scalpers, some of them haven't even noticed that there are some major changes underway. Lucky bunch eh?
- never ever let these wide ranges lure you into false sense of security of "it will be back to my price on the next pendulum swing anyway" kind. Market can stay insane much longer than you can stay solvent - keep your stops religiously.

3. Use this market as a tremendous learning opportunity even when you stay in cash.

This is a lifetime opportunity to learn. A lot of things that are usually muted and barely visible are very "in your face" right now.

Watch how major players react and interact - financial stocks, techs, metal-related. Watch how market reacts on news and rumors. Watch how breakouts work, how breakdowns work, how ranges hold. Watch market reactions on news and rumors. Watch which moves get follow-through and which get faded; try to get a feel for the difference so you would be able to tell in the future one from another. Watch when the market becomes totally unpredictable and erratic so that in the future you could recognize such situation as early as possible and go to cash.

Finally, one more thing to observe... it takes us back to our title:

4. History teaches us that it teaches us nothing.

Watch eternal cycle of hope based on denial and fear stemming from lack of understanding of market inner workings. Every piece of "good news" spat out by propaganda machine sparkles explosion of optimism - no matter how lame "news" is. Someone comes to TV and says something, with agenda or just striving for attention - and their words become a gospel or anathema, depending on listener's positioning in the market. Positions are being held despite market going against the holder. Positions are being taken and dumped out of pure emotions; rules are being abandoned. Emotions run high making people do a lot of stupid things. Observe it all as, just as in previous point, when the heat is that high all these things are seen very clearly . Such heightened tension as we have now serves as a photo film development.

It may sound a bit cynic at the time when the wealth is being destroyed at such rate, but let's say it again... as a trader consider yourself lucky to have such learning opportunity. Use it to its full extent.

Oh, and by the way... The quote that served as a title for this post is a cute simplified form. Full quote from Hegel is even more telling. “What experience and history teaches us is that people and governments have never learned anything from history, or acted on principles deduced from it”.

Trading Psychology - Stage 2. Acknowledgement.

So, our trader comes to realization that his inner mind a) greatly influences his trading performance and b) isn't always under his, trader's, control. Naturally, he wants to take control over himself - and this is what it is about, self-control.

You can view it in the same terms as you do in life in general. We all found ourselves in a number of situations where the right way to act was not what our emotions dictated. Boss whose thinking doesn not light up the office with knowledge and wisdom? Kid right behind you whose only purpose in life seems to be to pound your seat with his feet during whole flight? Chatty co-worker who doesn't let your button go until he enlightens you about all the plot twists of the soap opera you never knew existed? Leisure-minded driver in front of you who doesn't seem to recognize green as permission to move his foot from brake to gas? Go ahead, list all your gripes with the world, I'll wait couple minutes. OK, an hour.

... Done? Cool, let's continue. What is it that keeps you from giving all the offenders listed above the piece of or your mind (providing you do keep yourself in check)? Or, let's say, from grabbing the ice cream from the passerby when you happen to want it and he happens to have your favorite kind? Discipline does, reinforced by society customs that serve as limitations on our behavior. "Freedom of your fist ends where the freedom of my nose starts." Now, imagine all those limitations being removed and all reinforcements gone; and imagine that any negative outcomes of your action are limited to you only so no moral or ethical brakes either. Are you guaranteed to stay as disciplined and restrained? Heck, some can't even with all those restraining factors in force. Are you more likely now to give in to temptation and act your emotions out?

Probably yes. But that's exactly what we have in trading environment. There are no external factors keeping you from causing harm to your account. If you allow your emotions to take over and start governing your actions, no one stops to tell you "hey mister, what the heck do you think you are doing?". No one calls 911. Do as ya please and may it do ya fine - that's the psychological backdrop we deal with in the markets. With this realization comes understanding that in absence of external restraints we need much stronger self-discipline and self-control in order to continue following the rules.

Next question is, naturally, how? It starts with right understanding of the very nature of the market as an uncertain environment. Such understanding creates a foundation for the proper mindset. It continues with some strategies and tricks helping a trader form strong set of rules and motivations. My favorite are "Model Trader" and "If I Were Smarter" described in The Master Profit Plan . The process takes a while usually. How successful you are in creating the proper mindset and strict self-discipline will actually define how successful you are in trading.

Let's move on to the description of the third stage so you have a clear idea what you need to arrive to.

Trading Psychology - Stage 1. Blissful Unawareness.

As I mentioned in the previous post, first stage is usually the one where a newer trader doesn't acknowledge the role of psyhcology in his trading. It happens out of ignorance or arrogance.

In a former case (ignorance) it's simply lack of knowledge and mistaken notion that one can trade succeffully if given "right" system or indicator ot tip or whatever causes one to enter and exit his/her positions. It usually takes a while before a trader starts seeing how his mindset influences his trading and how his personal traits shine through his trading decisions. It comes as a surprize realization that different traders will get different results while trying to apply the same system. It is counter-intuitive, isn't it?

In a latter case (arrogance), a trader shows some kind of denial - it's "not me" attitude, thinking that goes along the lines "maybe it's a problem for some but I am in control of myself", "this stuff is for weak-minded" etc. Needless to say, it's rarely the case... and even more importantly, it's not so much about weak vs. strong mind as it is about influence one's personality has over one's trading.

In any case, the important thing at this stage is to come to appreciate this aspect of trading. It happens when one sees how much truth there is in saying "everyone gets what they want out of market" (Ed Seykota I think?) Again, seems counter-intuitive, right? After all, don't we all want to succeed, to make winning trades, to make money? Sure... but it's not what our conscious mind wants, it's about what our inner core dictates, and that is not always easy to realize and control.*

Simple example to illustrate the idea: do you know people who repeat certain behavior patterns harmful to themselves? Getting themselves into relationships with types that make them miserable, over and over again? Repeating the same mistakes in their interaction with others, obviously not learning from the past? I bet you do (although you personally never act like this, right?) So, why do we do it even though we see (or could see if we looked) that these behavioral patterns hurt us? Because those patterns are not just some easy to break habits; rather tthey are part of our personality, of who we are, and it takes much more than simple decision not to do that anymore to change our ways. Pretty much the same thing happens in trading - we know what not to do yet we continue doing it.

As soon as one realizes all this, the first stage is completed. The role of psychology in trading is acknowledged, denial is over - and this forms the foundation for a change.

*My favorite example of this phenomenon is one I referred to several times in earlier writings, although not on this blog I think - Russian movie Stalker. Briefly: there is a certain machine granting wishes (stalkers in the movie are people who take clients to it through many dangerous traps). Machine grants wishes alright but there is catch: it's not a wish that you stand in front of the machine and announce that will be granted... it's a wish that constitutes your essence, your core, your deep desire - and it's not necessary the one you realize and announce to yourself and to the world. Pretty much what happens in trading and pretty much what the author of that saying meant.

Psychology 101

One of those neverending debates among newer traders... role of psychology in trading. Some claim it's all there is to trading. Some argue it's nothing but red herring, and one just needs to follow his signals (system, indicators, whatever) and no psychobabble will ever be needed. Yet some say psychology is important and assign some weight to it - "80% of trading is psychology"... or 95%... Not sure how they measure it, I personally like 76.364%.

Two things to say about this.

First, we are different. Some simply cannot change their behavior and no matter what system they are given they just can't follow it. Their personality takes over pushing them into all kinds of trading no-nos. Then there are others who don't seem to experience any impact of their inner workings, they see the light and follow it. Obviously, the role of psychology will be drastically different for those two types.

Second, and most significant for most of us. We go through different stages in our learning curve. As far as trading psychology is concerned, I can clearly see three stages that are most common among traders.

First stage is total ignoring or underappreciation of this aspect of trading. By ignorance, by arrogance or for whatever else reason, a trader doesn't give it much thoughts while focusing on technical side of trading.

Second stage is acknowledgment. Running into troubles with their inner gear, reading books or listening to others, traders become aware of the ways their personality interferes with their trading. They have met the enemy.

Finally, third stage is dismissal of psychology again. Maybe dismissal is not the right word but that's how it feels for it's no longer needed. At this stage it becomes unneeded as a trader overcomes his inner barriers, changes himself, learns to behave in a right way and this correct behavior becomes second nature. Just as learning to swim you stop thinking of how to move when swimming, in the same way you stop giving time and thoughts to psychology of your trading again - seemingly returning to a first stage, although it's obviously another level you reach. You simply mastered it and stopped thinking about it.

It's important to understand that this third stage exists and make it your target to achieve it. Too many traders simply get stuck at the second stage - they think of it all the time, they make it their point of focus to such degree aand for so long that they just can't seem to get out of it. Development stops, they become locked in this endless inner digging. No need to rush through this second stage but to get stuck in it forever is no fun either.

In the following posts I intend to discuss each of those three stages a bit deeper. And, if you are lucky to belong to that second type, ignore this part of blog altogether. Check out the fourth stage though which discusses the highest craftsmanship of this side of trading.