We often hear that the markets trade on fear and greed and that is doubtlessly true. Rumor has it that amateurs often buy near the top and sell near the bottom. Why would that be? As a stock begins to move up, there often is little hype so only a few are buying. As the price moves upward, there is often more and more buzz so the public becomes aware of the stock and its movement. Many are still reluctant to buy, however, for fear that it will turn down. As it continues up, it is often accompanied by more and more volume. There is more and more hype. Finally, there may even be magazine articles about it; brokers may be cold calling and touting a buy. About then, there is a deluge of buying and the stock soars. Suddenly, however, the volume drys up. All who wanted to get in are in. Someone has to be the last one in and I suggest that those late to the party are jumping in because greed has finally overwhelmed their fear. Of course, the timing is awful.
Now our hypothetical trader has entered a position and wants the stock to go up. He chose that stock and he is emotionally involved. He has no thought that the stock will drop and no plan if it does. In our example, the stock soared just as he entered and volume dryed up. What do you suppose will happen to the price of the stock. Well, there are no more buyers at that high price so, in order to sell, the sellers must take a little less or sometimes a lot less. What is our friend doing now? I suspect he is worrying, and that makes him a grim buy and hold investor. He's in so he'll hold the position. As I asked in an earlier Article, hold the position until when? Until he dies? Maybe, but more likely until the fear once again rules his trading. As the stock drops, the drop is also often accompanied by increasing volume. Those who got in early are taking profits. Finally, those who got in late are making the argument to themselves: "I'll get out if only it goes back to 'x'." But it just keeps dropping and as it falls on high volume our trader sells. Why? Probably because he is afraid (fears) that it will fall some more. About that time, our trader sells. Now what? The sellers are gone. Everyone who wanted out is out so what will happen next?
Is that scenario a figment of my imagination or have you ever traded that way? Have you ever bought near the top and sold near the bottom? If you have, how did you arrive at your decision making? Have you seen others trade that way? Why did they do that?
As I have often opined, emotion is the serious enemy of the trader. I suggest that successful traders have made every decision before they ever enter a position. For example, if one is going to enter a trade because the stock is trending up, can you see any reason to stay in the trade if the uptrend is broken. If the trend is broken, the stock is no longer in an uptrend. Why would a trader want to continue to own a stock that is going down?
Before a trader buys that stock, couldn't he decide that he buy it because it looks like it is going up, but if it turns down below the trend, sell it. Notice I suggested he could make those decisions before buying the stock. Now is there any emotion involved in getting rid of the stock? No, as long as it stays above the uptrend line, the trader rides it up. When it breaks (or closes below) the trend, he sells. Now, the decision is relatively easy and unemotional. It certainly doesn't mean the trader will never lose; he will. There is no perfect trading system and all will have losses. One of the keys to successful trading is to cut losses. If the trader sells on a break below an uptrend has he cut losses? Another key to success is to let profits run. If the trader stays in until the trend is broken has he let profits run? Has he done that without emotion? Can each of those decisions be made before ever entering the position?
Discipline is critical and it is tough to discipline oneself in the heat of battle unless a plan has been formulated ahead of time. As has often been said, plan your trade and trade your plan. One of the problems I have often seen with people who have come to my classes is that they do well when they practice trade or paper trade. They have a plan and follow it, but when they start to use real money, they forget their own plan and their own rules. Can you guess what happens when they abandon the plan that was so successful when paper trading? Sometimes they forget money management and after several good trades "bet it all on black." Guess what happens then. "Betting it all on black" or XYZ stock is purely the product of greed. It is unlikely that a seasoned trader would do that. Sometimes, they plan their trade to have an exit at a specific place, but when the stock drops below they hang on saying to themselves: "It'll come back." Sometimes it does come back, but why tie up money with a stock that you want to go up is going down?
Refer back to my Article on the business plan if you want. Make your own plan. Continue your education. It's your money and it's your risk. Continue to learn as much as you can about discipline, about strategies, about yourself and about how to remove the emotion from trading.
Bill Kraft, Editor