Trading in the market is one of those things…
It can result in consistent, profitable yields or devastating losses from which one may never recover—especially to the new, or middle-class investor. There are those who ask me constantly, “isn’t investing in stocks just gambling?”—to which I smile politely and attempt to explain why most outsiders feel this way. Those who wish to participate in the market need to respect its vastness and depth. I liken the stock market to that old jungle cliché —because everything lurking does want to hurt you. Couple that with a great degree of uncertainty, and its plain to see that one must approach trading with purpose, discipline, open-mindedness and most importantly, patience.
The bottom line of what I try to tell them, if you are a middle-class earner and you think the market will make you the next Warren Buffett, you are headed for some immediate letdowns and potential disasters. This is especially true for the market we’ve seen in the last while.
Success in trading is not just a function of one component. It is a function of three components or resources that form the cornerstones of a trading foundation; the building blocks of an effective market strategy. These resources are categorized under Behavioral, Fundamental and Technical Analyses.
I. Behavioral Analysis
In order to trade the market, you must first develop an understanding of what the market is. A market provides a venue or an environment for determining the balance or equilibrium point for the demand and supply of an asset. The demand and supply of an asset is influenced by the number of buyers and sellers participating in the market. As the participants move to find the equilibrium point between demand and supply, the market is subjected to various forces that constantly shift the advantage between buyers and sellers. These forces reflect the underlying psychology of the market. Thus, for a trader to become successful in the market he or she must develop an understanding of the forces that influence market behavior. These can be broken down into a separate items:
- Psychology of the Market: The trader must acknowledge that the market is made up of thousands of unique individuals with different personalities. They react, observe, view, and analyze the market differently. Thus, we can make an argument that the psychology of the market is irrationa,l which explains why group behavior otherwise referred to as “Collective Psychology” is prevalent. An individual who joins a collective loses all rationality as he is carried over by the general sentiment of the group.
- Dimensional Analysis of the Market: The trader should develop a key understanding of the three components that drive markets: Price, Volume and Time.
The movement of price is dictated by the shifts in forces between the buyers and sellers in the market. Stronger buyer movement brings prices up and inversely, stronger selling action moves prices down.
Volume is generated by the forces that influence the decisions of the buyers and sellers in the market and is a consequence of news, information and other factors that enter the market.
Time refers to the period in which the trader wants to trade. Is he a fund manager who seeks long-term trading positions, or an intra-day trader who wants to exit the market before close of market?
Collectively, price, volume and time will determine the movement of the market and give the trader a firm perspective on its underlying behavior.
Understanding Risks in Trading
Success in trading is not just determined by having a well-structured, well-researched trading plan and skills enhanced by constantly working to improve competencies in technical and trading analysis. A lesser known key to achieving consistent success in the market is the trader’s acknowledgement of the value of risk management policies.
Obviously, people who enter the market do so with the objective of earning an appreciable level of profit. But profit in market trading is a function of earnings and losses. It is not enough that a trader focuses his or her resources only on mechanisms and strategies toward achieving profit. He or she must develop a set of policies or guidelines that determine the amount of risk s/he is willing to take. This ensures the protection of trading capital.
II. Fundamental Analysis
This is one of the two core approaches to market analysis and remains the prevalent methodology among traders today. Fundamental analysis refers to the use of reports, economic data, newsfeed and other informative media that relates to the value of an asset or commodity. Traders can source data to formulate their fundamental analyses online and via media channels such as Bloomberg, RanSquawk and Reuters plus traditional sources such as stockholder’s meetings. Professional Fund Managers who favor long-term position trading often use sources from inside corporations of traded securities to gain first-hand information on developments that could influence market movement. There are generally three key areas of Fundamental Analysis:
- Corporate Value: Factors such as earnings, dividend yield, asset valuation and bond/stock yield of a security are collated, broken down and analyzed to come up with a specific recommendation.
- Economic Factors: These are factors that affect demand and supply in the economy such as the rate of inflation, level of unemployment, manufacturing and non-farm payrolls, new job creation, and foreign currency fluctuation.
- Government Policies: Investors and traders are always on the lookout for information on government policies that could have an effect on taxation, trade policies, credit accommodations for foreign investors, plus conditions that could adversely affect market confidence such as wars, political unrest and general elections.
Using Market Indicators
These are systems that are formulated to help the trader find points of entry, exit, and stops during periods of trading. Some of these systems, such as Stochastics, measure trading volume while another one, the Relative Strength Index or RSI, measures the levels of buying and selling. Seasoned technical traders use indicators in conjunction with price levels to look for Divergence levels. A Divergence level is the point where any further increase in price is supported by declining levels of buying volume or strength which may indicate a market reversal is imminent.
You can dig deeper into Fundamental Analysis here.
III. Technical Analysis
The second core approach to market analysis is highly misunderstood. Technical analysis is not just the use of tools and processes, the majority of which are based on mathematics and science. More accurately, it can be used to measure market psychology by studying the underlying structure of the market. When a trader uses Technical Analysis, s/he is asking the question, “What is the market trying to tell me?” Thus, the successful application of any tool or system of Technical Analysis must have a substantial basis to answer that question.Understanding Market Structure: All modes of Technical Analysis must start with understanding market structure. Traders are usually indoctrinated in Technical Analysis through the use of trend lines and channels to determine support and resistance levels. Other forms of Technical Analysis that study market structure are:
- Dow Theory: This approach uses shapes and formations to determine market movement, including trends and reversals.
- Elliott Wave Theory: Formulated by Ralph Elliott, this theory assumes that collective investor behavior moves in patterns or waves; an impulsive 5-wave pattern and an ensuing corrective 3-wave pattern.
- Fibonacci Ratios: This is based on a “Golden Ratio” that can be used to measure the relative proportions of nature’s smallest units, such as the atom, to the most advanced patterns in the Universe. Fibonacci Ratios are used to measure retracements and price targets.
Read more on Technical Analysis here.
The Bottom Line
The final reality that traders need to acknowledge before they decide to participate in the market is that regardless of their level of planning, preparation, consultation and research, failure and the actualization of losses is a non-negotiable truism in the world of trading.
Everyone who engages in the markets will inevitably fail so to speak.
The realization of failure is not meant to discourage traders but rather open their minds to the underlying and all-encompassing truth that the market is so vast and powerful it can never be cornered or controlled by any one entity or group of entities.
Thus, while traders enter the market for the purpose of generating profits, they should remain mindful that risks exist and therefore, discipline and caution must be exercised every single trading day. Greed will leave you bruised. Much like a batter at the plate, if you’re constantly swinging for the fences (i.e. trying to get rich quick), you’re going to strike out more often than not—with devastating results. I take a Chipper Jones approach to trading: Swing for singles and play the percentages. Sometimes you’ll finish with a double or a triple. Home runs are nice, but if they are your sole focus, you are putting yourself under unnecessary pressure and great risk.
Fun fact, Jones holds the Atlanta Braves record for career on-base percentage—yet sits in third place on the team’s all-time home run list… Mr. Consistent. Keep that in mind next time you step up to the dish.