Emotion and Stock Trading

 


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The stock market is driven solely by human emotion. Nothing else really matters. Human emotion is driven by perception, and perception is jaded by expectations. If your expectations are not met, than your perception is that this is bad. So if your expectations are high, chances are you will be disappointed. The trick then is to gauge the expectations that stock traders have at any given moment. Unfortunately there is no reliable measurement that I know of to gauge expectations.

Much of any days movement can be attributed to the daily news. And most of the time it can be narrowed down to the day's economic news. There are of course non-economic events that shape the trader's expectations. Politics, war, disasters, etc. , but barring any unusual activity in these areas, the economic news is the driving force of most trading day's activity. The notable exception is during ‘earnings season', but we will be writing a whole article covering this at a later date. Suffice it to say however, earnings are the epitome of our theme presented here. Traders usually have scenarios in their heads, expectations if you will. They expect inflation to fall or rise, interest rates therefore will either fall or rise in lock step fashion with inflation. Indicators are used to predict inflation such as productivity, employment, consumer sentiment etc. And traders, have expectations of all these figures as the month goes on. They use their expectations to gauge whether these numbers come in as good news or bad news. In high inflationary times, a report on higher unemployment actually becomes a positive. Because higher unemployment means consumers have less money, thereby inflationary pressures will ease. But if the economy is perceived to be in a recession, than a report on higher unemployment is seen as negative, because we are not likely to pull ourselves out without people working.

And then to add to the confusion there are times when the numbers come in better than expected and the market still tanks. What gives to all of this confusing melting pot of expectations, perceptions and emotions? Well, one thing I can tell you, don't read too much into the standard market reports given at the end of the trading day. They are valuable in that they are nothing more than a report driven by the same emotions that drive the market. However, their downfall is that they fail to recognize this. Daily reports report the exact condition of the human psyche, without ever recognizing that the psyche is the market. They can't separate the two, and therefore their weakness is, that the psyche is an ever changing environment, and rarely stays the same two days in a row. Unless there is that rare and exceptional event that the whole world is focusing on. Sometimes the market just sells off, because it is time to. Sometimes it rallies because is just time to. If our expectations are that the market will go higher, because the economic data points that way, it will. But there will come a time, when the economic data fail to, or when our rosier than rosy scenario, shows a chink somewhere in that shining armor. And viola, nobody buys that day, or two days or week. Nothing in reality has changed except our emotions.

The trick to making money off all this is, watch the expectations. Watch the perceptions, and then watch the technical factors of the market, and the industries. If there is a bull move in housing say. And the underlying factors are there for home building, i. e. low interest rates. And the industry is moving along just fine, without speculative fever. This is the time you watch it, and wait. There will be some bad news along the way. Maybe even just a pause in housing permits, maybe an uptick in interest rates, for a very silly reason. And watch the band wagon empty out. This is when you buy, not while it is falling, but when it stops falling. This is the easiest band wagon to jump on. One that is stopping at the bus stop. Don't jump on the moving bus, wait for it to stop. Likewise that is when you jump off too, not after it has gone into reverse. But when it has stopped. The easiest part of any move, is the middle part. The beginning is hard to see, the end is full of unpredictability and wild price changes, but ahh that middle. The boring old middle, full of narrow trading days, and small incremental price jumps. Nobody prints articles about that, it isn't sexy or romantic. It is just profitable.

The other nice thing about the middle of any move, is it is backed by solid economic data in its favor. Any time there is unfortunate reports, people jump off slowly. The uptrend stops, not reverses. Because speculation hasn't hit yet. Expectations are not unrealistic. And it doesn't show up in the daily reports yet. The daily reports are filled with information about sectors that are either at the bottom or the top of their speculative run. Because without recognizing it they are reporting on the sectors that have the strongest emotions. And the two strongest emotions driving the market are none other than fear and greed. And when are fear and greed are at their most prominent, at the top and the bottom.

Trade without fear and greed, and you will trade well.

Now what to do about those daily reports? How to trade off of them? You trade opposite them. Not the day they are printed. When oil or housing are booming out of control and EVERYONE is talking about it. You put large cap oil and housing stocks on your watch list and wait. A month or two or three it isn't exact science here. Dealing with human emotions never is, just ask Freudians. But you wait, until they stop making news highs, until they start making lower highs, then you short them. Or vice versa when techs crashed. You wait, and when they stop making lower lows, you buy them. But not just any stocks, large caps, quality stocks with real value, like earnings, assets, maybe even a dividend or two. Shorting large caps makes sense too, as they are easier to borrow, and they pretty much follow the trend, in fact in many industries they are the trend.

Trade without fear and greed, and you will trade well. Think for yourself and you will trade well. I encourage you to read my daily blog at http://livingonlargecaps.blogspot.com

For real time trading following these and other common sense principles.

CT Larsen has been trading stocks since 1990. Now trading large cap stocks exclusively. He has recorded three straight years of greater than 50% annual returns. You can read his blog at http://livingonlargecaps.blogspot.com

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