Showing posts with label the-new-trading-for-a-living-pdf-tieng-viet. Show all posts
Showing posts with label the-new-trading-for-a-living-pdf-tieng-viet. Show all posts

THE NEW TRADING OF A LIVING- MASS PSYCHOLOGY

THE NEW TRADING OF A LIVING



MASS PSYCHOLOGY

Wall Street is named after a wall that kept farm animals from wandering away from the settlement at the southern tip of Manhattan. The farming legacy lives on in the language of traders. Four animals are mentioned especially often on Wall Street: bulls and bears, hogs and sheep. Traders say: “Bulls make money, bears make money, but hogs get slaughtered.”

A bull fights by striking up with his horns. A bull is a buyer—a person who bets on a rally and profits from a rise in prices. A bear fights by striking down with his paws. A bear is a seller—a person who bets on a decline and profits from a fall in prices.

Hogs are greedy. Some of them buy or sell positions that are too large for their accounts and get slaughtered by a small adverse move. Other hogs overstay their positions—they keep waiting for profits even after the trend reverses. Sheep are passive and fearful followers of trends, tips, and gurus. They sometimes put on a bull’s horns or a bearskin and try to swagger. You can recognize them by their pitiful bleating when the market becomes volatile.

Whenever the market is open, bulls are buying, bears are selling, hogs and sheep get trampled underfoot, and the undecided traders wait on the sidelines. Quote screens around the world show a steady stream of the latest prices for any trading vehicle. Thousands of eyes are focused on each price as people make trading decisions.

What Is Price?

Traders can be divided into three groups: buyers, sellers, and undecided. Buyers want to pay as little as possible, and sellers want to charge as much as possible. Their permanent conflict is reflected in bid-ask spreads, discussed in the Introduction. “Ask” is what a seller asks for his merchandise. “Bid” is what a buyer offers for that merchandise.

A buyer has a choice: to wait until prices come down or pay what the sellers demand. A seller has a similar choice: wait until prices rise or accept a lower offer for his merchandise.

A trade occurs when there is a momentary meeting of two minds: an eager bull agrees to a seller’s terms and pays up, or an eager bear agrees to a buyer’s terms and sells a little cheaper.

The presence of undecided traders puts pressure on bulls and bears. Buyers and sellers move fast because they know that they’re surrounded by a crowd of undecided traders who may step in and snatch away their deal at any moment.

The buyer knows that if he thinks too long, another trader can step in and buy ahead of him. A seller knows that if he tries to hold out for a higher price, another trader may step in and sell at a lower price. The crowd of undecided traders makes buyers and sellers more willing to deal with their opponents. A trade occurs when there is a meeting of two minds.

A Consensus of Value

Each tick on your quote screen represents a deal between a buyer and a seller. Buyers are buying because they expect prices to rise. Sellers are selling because they expect prices to fall. Buyers and sellers are surrounded by crowds of undecided traders who put pressure on them because they may become buyers or sellers themselves.

Buying by bulls pushes markets up, selling by bears pushes them down, and undecided traders make everything happen faster by creating a sense of urgency among buyers and sellers.

Traders come to the markets from all over the world: in person, via computers, or through their brokers. Everybody has a chance to buy and to sell. Each price is a momentary consensus of value of all market participants, expressed in action. Prices are created by masses of traders—buyers, sellers, and undecided people. The patterns of prices and volume reflect mass psychology of the markets.

Behavior Patterns

Huge crowds trade on stock, commodity, and option exchanges. Big money and little money, smart money and dumb money, institutional money and private money, long-term investors and short-term traders, all meet at the exchange. Each price represents a momentary consensus of value between buyers, sellers, and undecided traders at the moment of transaction. There is a crowd of traders behind every pattern on the screen.

Crowd consensus changes from moment to moment. Sometimes it gets established in a very low-key environment, and at other times the environment turns wild. Prices move in small increments during quiet times. When a crowd becomes either spooked or elated, prices begin to jump. Imagine bidding for a life preserver aboard a sinking ship—that’s how prices leap when masses of traders become emotional about a trend. An astute trader aims to enter the market during quiet times and take profits during wild times. That, of course, is the total opposite of how amateurs act: they jump in or out when prices begin to run, but grow bored and not interested when prices are sleepy.

Chart patterns reflect swings of mass psychology in the financial markets. Each trading session is a battle between bulls, who make money when prices rise, and bears, who profit when they fall. The goal of a serious technical analyst is to discover the balance of power between bulls and bears and bet on the winning group. If bulls are much stronger, you should buy and hold. If bears are much stronger, you should sell and sell short. If both camps are about equal in strength, a wise trader stands aside. He lets bulls and bears fight with each other, and enters a trade only when he is reasonably sure which side is likely to win.

Prices and volume, along with the indicators that track them, reflect crowd behavior. Technical analysis is similar to poll taking. Both combine science and art: They are partly scientific because we use statistical methods and computers; they are partly artistic because we use personal judgment and experience to interpret our findings.

What Is the Market?

What’s the reality behind market quotes, numbers, and graphs? When you check prices in your newspaper, follow ticks on your screen, or plot an indicator on a chart, what exactly are you looking at? What is this market that you want to analyze and trade?

Amateurs act as if the market is a giant happening, a ball game in which they can join the professionals and make money. Traders from a scientific or engineering background often treat the market as a physical event and apply the principles of signal processing, noise reduction, etc. By contrast, all professional traders know full well that the market is a huge mass of people.

Every trader tries to take money from others by outguessing them on the probable direction of the market. The members of the market crowd live on different continents, but are brought together by modern telecommunications in the pursuit of profit at each other’s expense. The market is a huge crowd of people. Each member of the crowd tries to take money from others by outsmarting them. The market is a uniquely harsh environment because everyone is against you, and you are against everyone.

Not only is the market harsh, you have to pay whenever you enter and exit. You have to jump over the barriers of commissions and slippage before you can collect a dime. The moment you place an order, you owe your broker a commission—you’re behind the game the moment you enter. Market makers try to hit you with slippage when your order arrives for execution. They try to take another bite out of your account when you exit. In trading, you compete against some of the brightest minds in the world, while fending off the piranhas of commissions and slippage.

Worldwide Crowds

In the old days, markets were small, and many participants knew one another. The New York Stock Exchange was formed in 1792 as a club of two dozen brokers. On sunny days, they used to gather under a cottonwood tree, and on rainy days, they moved to Fraunces Tavern. As soon as those brokers organized the New York Stock Exchange, they stuck the public with fixed commissions, which lasted for the next 180 years.

These days, the few remaining floor traders are on the way out. Most of us are linked to the market electronically. Still, as we watch the same quotes on our screens and read the same articles in the financial media, we become members of the market crowd—even if we live thousands of miles away from one another. Thanks to modern telecommunications, the world is becoming smaller, while the markets are growing. The euphoria of London flows to New York, and the gloom of Tokyo infects Frankfurt.

When you analyze the market, you are looking at crowd behavior. Crowds behave alike in different cultures on different continents. Social psychologists have uncovered several laws that govern crowd behavior, and a trader needs to understand them in order to see how the market crowd influences him.

Groups, Not Individuals

Most people feel a strong urge to join the crowd and “act like everybody else.” This primitive urge clouds your judgment when you put on a trade. A successful trader must think independently. He needs to be strong enough to analyze the market alone and carry out his trading decisions.

Crowds are powerful enough to create trends. The crowd may not be too bright, but it is stronger than any of us. Never buck a trend. If a trend is up, you should only buy or stand aside. Never sell short just because “the prices are too high”—never argue with the crowd. You do not have to run with the crowd—but you shouldn’t run against it.

Respect the strength of the crowd—but don’t fear it. Crowds are powerful, but primitive, their behavior simple and repetitive. A trader who thinks for himself can take money from crowd members.

The Source of Money

Do you ever stop to wonder where your expected profits will come from? Is there money in the markets because of higher company earnings, or lower interest rates, or a good soybean crop? The only reason there is money in the markets is that other traders put it there. The money you want to make belongs to other people who have no intention of giving it to you.

Trading means trying to take money from other people, while they are trying to take yours—that’s why it is such a hard business. Winning is especially difficult because brokers and floor traders take money from winners and losers alike.

Tim Slater compared trading to a medieval battle. A man used to go on a battlefield with his sword and try to kill his opponent, who was trying to kill him. The winner took the loser’s weapons, his chattels, and his wife, and sold his children into slavery. Now we go to the exchanges instead of an open field. When you take money away from a man, it is not that different from drawing his blood. He may lose his house, his chattels, and his wife, and his children will suffer.

An optimistic friend of mine once snickered that there are plenty of poorly prepared people on the battlefield: “Ninety to ninety-five percent of the brokers don’tknow the first thing about research. They don’t know what they’re doing. We have the knowledge, and some poor people who do not have it are just giving their money away to charity.” This theory sounds good, but he soon found out that it was wrong—there is no easy money in the market.

Sure enough, there are plenty of dumb sheep waiting to be fleeced or slaughtered. The sheep are easy—but if you want a piece of their meat, you’ve got to fight some very dangerous competitors. There are mean professionals: American gunslingers, English knights, German landsknechts, Japanese samurai, and other warriors, all going after the same hapless sheep. Trading means battling crowds of hostile people, while paying for the privilege of entering the battle and leaving it, whether alive, wounded, or dead.

Inside Information

There is at least one group of people who get information before us. Records show that corporate insiders as a group consistently make profits in the stock market. And those are legitimate trades, reported by insiders to the Securities and Exchange Commission. They represent the tip of the iceberg—but there is a great deal of illegitimate insider trading.

People who trade on inside information are stealing our money. The insider trials have landed some of the more notorious insiders in prison. Convictions for insider trading continue at a steady pace, especially after bull markets collapse. After the 2008 debacle, a group of executives from the Galleon fund, led by its CEO, have been sentenced to lengthy jail terms, while a former board member of several leading U.S. corporations got two years behind bars, and recently a money manager from SAC Capital was convicted.

People convicted during the insider trials were caught because they became greedy and careless. The tip of the iceberg has been shaved down, but its bulk continues to float, ready to hit any account that comes in contact with it.

Trying to reduce insider trading is like trying to get rid of rats on a farm. Pesticides keep them under control, but do not root them out. A retired chief executive of a publicly traded firm explained to me that a smart man does not trade on inside information but gives it to his golfing buddies at a country club. Later they give him inside information on their companies, and both profit without being detected. The insider network is safe as long as its members follow the same code of conduct and don’t get too greedy. Insider trading is legal in the futures markets, and until recently it was legal for congressmen, senators, and their staff.

Charts reflect all trades by all market participants—including insiders. They leave their footprints on the charts just like everyone else—and it is our job as technical analysts to follow them to the bank. Technical analysis can help you detect insider buying and selling.

The Trading Scene

Humans have traded since the dawn of history—it was safer to trade with your neighbors than raid them. As society developed, money became the medium of exchange. Stock and commodity markets are among the hallmarks of an advanced society. One of the key economic developments in Eastern Europe following the collapse of communism was the establishment of stock and commodity exchanges.

Today, stock, futures, and options markets span the globe. It took Marco Polo, a medieval Italian merchant, 15 years to get from Italy to China and back. Now, when a European trader wants to buy gold in Hong Kong, he can get his order filled in seconds. There are hundreds of stock and futures exchanges around the world. All exchanges must meet three criteria, first developed in the agoras of ancient Greece and the medieval fairs of Western Europe: an established location, rules for grading merchandise, and defined contract terms.

Individual Traders

Private traders usually come to the market after a successful career in business or in the professions. An average private futures trader in the United States is a 50-year-old, married, college-educated man. The two largest occupational groups among futures traders are farmers and engineers.

Most people trade for partly rational and partly irrational reasons. Rational reasons include the desire to earn a large return on capital. Irrational reasons include gambling and a search for excitement. Most traders are not aware of their irrational motives.

Learning to trade takes time, money, and work. Few individuals rise to the level of professionals who can support themselves by trading. Professionals are extremely serious about what they do. They satisfy their irrational goals outside the markets, while amateurs act them out in the marketplace.

The major economic role of a trader is to support his broker—to help him pay his mortgage bills and keep his children in private schools. In addition, the role of a speculator is to help companies raise capital in the stock market and to assume price risk in the commodities markets, allowing producers to focus on production. These lofty economic goals are far from a speculator’s mind when he places his orders to buy or sell.

Institutional Traders

Institutions are responsible for a huge volume of trading, and their deep pockets give them several advantages. They pay low institutional commissions. They can afford to hire the best researchers and traders. A friend of mine who headed a trading desk at a bank based some of his decisions on a service provided by a group of former CIA officers. He got some of his best ideas from their reports, while the substantial annual fee was small potatoes for his firm compared to its huge trading volume. Most private traders do not have such opportunities.

Some large firms have intelligence networks that enable them to act before the public. One day, when oil futures rallied in response to a fire on a platform in the North Sea, I called a friend at an oil firm. The market was frantic, but he was happy, having bought oil futures half an hour before they exploded. He got a telex from an agent in the area of the fire before the reports appeared on the newswire. Timely information is priceless, but only a large company can afford an intelligence network.

An acquaintance who traded successfully for a Wall Street investment bank felt lost when he quit to trade for himself. He discovered that a real-time quote system in his Park Avenue apartment didn’t give him news as fast as the squawk box on the trading floor of his old firm. Brokers from around the country used to call him with the latest ideas because they wanted his orders. “When you trade from your house, you are never the first to hear the news,” he says.

The firms that deal in both futures and cash markets have two advantages. They have true inside information, and they are exempt from speculative position limits that exist in many futures markets. I went to visit an acquaintance at a multinational oil company; after passing through security barriers tighter than at an airport, I walked down a glass corridor that overlooked rooms where clusters of men huddled around monitors trading oil products. When I asked my host whether his traders were hedging or speculating, he looked me straight in the eye and said, “Yes.” I asked again and received the same answer. Companies crisscross the thin line between hedging and speculating, using inside information.

In addition to the informational advantage, employees of trading firms have a psychological one—they can be more relaxed because their own money isn’t at risk. When young people tell me of their interest in trading, I tell them to get a job with a trading firm and learn on someone else’s dime. Firms almost never hire traders past their mid-twenties.

How can an individual coming later to the game compete against institutions and win? The Achilles heel of most institutions is that they have to trade, while an individualtrader is free to trade or stay out of the market when he wants. Banks have to be active in the bond market and grain producers have to be active in the grain market at almost any price. An individual trader is free to wait for the best opportunities.

Most private traders fritter away this fantastic advantage by overtrading. An individual who wants to succeed against the giants must develop patience and eliminate greed. Remember, your goal is to trade well, not to trade often.

Successful institutional traders receive raises and bonuses. Even a high bonus can feel puny to someone who earns millions of dollars for his firm. Successful institutional traders often talk of quitting and going to trade for themselves. Very few of them manage to make this transition.

Most traders who leave institutions get caught up in the emotions of fear, greed, elation, and panic when they start risking their own money. They seldom do well trading for their own accounts—another sign that psychology is at the root of trading success or failure. Few institutional traders realize to what a large extent they owe their success to their trading managers, who control their risk levels. Going out on your own means becoming your own manager—we’ll return to this, when we focus on how to organize your trading.

The Sword Makers

Just as medieval knights shopped for the sharpest swords, modern traders shop for the best trading tools. The growing access to good software and declining commission rates are creating a more level playing field. A computer allows you to speed up your research and follow more leads. It helps you analyze more markets in greater depth.

There are three types of trading software: toolboxes, black boxes, and gray boxes.
A toolbox allows you to display data, draw charts, plot indicators, change their parameters, and test your trading systems. Toolboxes for options traders include option valuation models. Adapting a good toolbox to your needs can be as easy as adjusting the seat of your car.

In 1977, I bought the first ever toolbox for computerized technical analysis. It cost $1,900 plus monthly data fees. Today, inexpensive, and even free, software places powerful tools at everyone’s fingertips. I illustrated most of the concepts in this book using Stockcharts.com because I wanted my new book to be useful to as many traders as possible.

Stockcharts.com evens out the playing field for traders. It is clear, intuitive, and rich in features. Its basic version is free, although I used its inexpensive “members’ version” for higher quality charting. I still remember how hard it was in the beginning and want to show you how much analytic power you can have for free or at a very minimal cost.

What goes on inside a black box is secret. You feed it data, and it tells you what and when to buy and sell. It is like magic—a way to make money without thinking. Black boxes are usually sold with excellent historical track records. This is only natural because they were created to fit old data. Markets keep changing, and black boxes keep blowing up, but new generations of losers keep buying them. If you’re in the market for a black box, remember that there is a guy in Brooklyn who has a bridge for sale.

Gray boxes straddle the fence between toolboxes and black boxes. These packages are usually put out by prominent market personalities. They disclose the general logic of their system and allow you to adjust some of their parameters.

Advisors

Some newsletters provide useful ideas and point readers in the direction of trading opportunities. A few offer educational value. Most sell an illusion of being an insider. Newsletters are good entertainment. Your subscription rents you a pen pal who sends often amusing and interesting letters and never asks you to write back, except for a check at renewal time. Freedom of the press in the United States allows even a convicted felon to go online and start sending out a financial advisory letter. Quite a few of them do.

The “track records” of various newsletters are largely an exercise in futility because hardly anybody takes every trade suggested by a newsletter. Services that rate newsletters are for-profit affairs run by small businessmen whose well-being depends on the well-being of the  advisory industry. Rating services may occasionally tut-tut an advisor, but they dedicate most of their energy to loud cheerleading.

I used to write an advisory newsletter decades ago: worked hard, delivered straight talk, and received good ratings. I saw from the inside a tremendous potential for fudging results. This is a well-kept secret of the advisory industry.

After looking at my letters, a prominent advisor told me that I should spend less time on research and more on marketing. The first principle of letter writing is: “If you have to make forecasts, make a lot of them.” Whenever a forecast turns out right, double the volume of promotional mail.

The Market Crowd and You

Markets are loosely organized crowds whose members bet that prices will rise or fall. Since each price represents crowd consensus at the moment of transaction, traders are betting on the future opinion and mood of the crowd. The crowd keeps swinging from hope to fear and from indifference to optimism or pessimism. Most people don’t follow their own trading plans because they get swept up in the crowd’s feelings and actions.

As bulls and bears battle in the market, the value of your open positions soars or sinks, depending on the actions of total strangers. You can’t control the markets. You can only set your position size and decide whether and when to enter or exit your trades.

Most traders feel jittery entering a trade. Their judgment becomes clouded after they join the crowd. Caught up in crowd emotions, many traders deviate from their plans and lose money.

Experts on Crowds

Charles Mackay, a Scottish barrister, wrote his classic book, Extraordinary Popular Delusions and the Madness of Crowds, in 1841. He described several mass manias, including the Tulip Mania in Holland in 1634 and the South Seas investment bubble in England in 1720.

The tulip craze began as a bull market in tulip bulbs. The long bull market convinced the prosperous Dutch that tulips would continue to appreciate. Many abandoned their businesses to grow tulips, trade them, or become tulip brokers. Banks accepted tulips as collateral and speculators profited. Finally, that mania collapsed in waves of panic selling, leaving people destitute and the nation shocked. Mackay sighed, “Men go mad in crowds, and they come back to their senses slowly and one by one.”

In 1897, Gustave LeBon, a French philosopher and politician, wrote The Crowd. A trader who reads it today can see his reflection in a century-old mirror.

LeBon wrote that when people gather in a crowd, “Whoever be the individuals that compose it, however like or unlike be their mode of life, their occupations, their character, or their intelligence, the fact that they have been transformed into a crowd puts them in possession of a sort of collective mind which makes them feel, think, and act in a manner quite different from that in which each individual of them would feel, think, and act were he in a state of isolation.”

People change when they join crowds. They become more credulous and impulsive, anxiously search for a leader, and react to emotions instead of using their intellect. An individual who becomes involved in a group becomes less capable of thinking for himself.

Group members may catch a few trends, but they get killed when trends reverse. Successful traders are independent thinkers.

Why Join?

People have been joining crowds for safety since the dawn of time. If a Stone Age hunter encountered a saber-toothed tiger, he had a very slim chance of coming out alive, but if hunters went as a group, most were likely to survive. Loners got killed and left fewer offspring. Since group members were more likely to survive, the tendency to join groups appears to have been bred into our genes.

Our society glorifies free will, but we carry many primitive impulses beneath the thin veneer of civilization. We want to join groups for safety and be led by strong leaders. The greater the uncertainty, the stronger our wish to join and to follow.

No saber-toothed tigers roam the canyons of Wall Street, but your financial survival is at risk. The value of your position rises and falls because of buying and selling by total strangers. Your fear swells up because you can’t control prices. This uncertainty makes most traders look for a leader who will tell them what to do.

You may have rationally decided to go long or short, but the moment you put on a trade, the crowd starts sucking you in. You start losing your independence when you watch prices like a hawk and become elated when they go your way or depressed if they go against you. You are in trouble when you impulsively add to losing positions or reverse them. You lose your independence when you start trusting gurus more than yourself and don’t follow your own trading plan. When you notice this happening, try to come back to your senses. If you can’t regain your composure, exit your trades and go flat.

Crowd Mentality

When people join crowds, their thinking becomes primitive and they become more prone to act on impulse. Crowds swing from fear to glee, from panic to euphoria. A scientist can be cool and rational in his lab but make harebrained trades after being swept up in the mass hysteria of the market. A group can suck you in, whether you trade from a crowded brokerage office or a remote mountaintop. When you let others influence your trading decisions, your chance of success goes up in smoke.

Group loyalty was essential for a prehistoric hunter’s survival. Joining a union can help even an incompetent performer keep his job. The market is different: joining a group tends to hurt you.

Many traders are puzzled why markets reverse immediately after they dump their losing position. This happens because crowd members are gripped by the same fear—and everybody dumps at the same time. Once the selling fit has ended, the market has nowhere to go but up. Optimism returns to the marketplace, and the crowd forgets fear, grows greedy, and goes on a new buying binge.

The crowd is bigger and stronger than you. No matter how smart you are, you cannot argue with the crowd. You have only one choice—to join the crowd or to act independently.

Crowds are primitive, and your trading strategies should be simple. You don’t have to be a rocket scientist to design a winning trading method. If the trade goes against you—cut your losses and run. Never argue with the crowd—simply use your judgment to decide when to join and when to leave.

Your human nature leads you to give up your independence under stress. When you put on a trade, you feel the desire to imitate others, overlooking objective signals. This is why you need to write down and follow your trading system and money management rules. They represent your rational individual decisions, made before you entered a trade.

Who Leads?

An inexperienced trader may feel intense joy when prices move in his favor. He may feel angry, depressed, and fearful when prices move against him, anxiously waiting to see what the market will do to him next. Traders become crowd members when they feel stressed or threatened. Battered by emotions, they lose their independence and begin imitating other group members, especially the group leader.

When children feel frightened, they want their parents and other grown-ups to tell them what to do. They transfer that attitude to teachers, doctors, ministers, bosses, and assorted experts. Traders turn to gurus, trading system vendors, newspaper columnists, and other market leaders. But, as Tony Plummer brilliantly pointed out in his book, Forecasting Financial Markets, the main leader of the market is price.

Price is the leader of the market crowd. Traders all over the world follow the upticks and downticks. Price seems to say to traders, “Follow me, and I’ll show you the way to riches.” Most traders consider themselves independent. Few of us realize how strongly we focus on the behavior of our group leader.

A trend that flows in your favor symbolizes a strong and generous parent calling you to share a meal. A trend that goes against you feels like dealing with an angry and punishing parent. Being gripped by such feelings, it’s easy to overlook objective signals that tell you to stay or to exit a trade. You may feel happy or frightened, bargain or beg forgiveness—while avoiding the rational act of accepting reality and getting out of a losing trade.

Independence

You need to base your trades on a carefully prepared plan instead of jumping in response to price changes. A proper plan is a written one. You need to know exactly under what conditions you will enter and exit a trade. Don’t make decisions on the spur of the moment, when you are vulnerable to being sucked in by the crowd.

You can succeed as a trader only when you think and act as an individual. The weakest part of any trading system is the trader himself. Traders fail when they trade without a plan or deviate from their plans. Plans are created by reasoning individuals. Impulsive trades are made by sweaty group members.

You have to observe yourself and notice changes in your mental state as you trade. Write down your reasons for entering a trade and the rules for getting out of it, including money management rules. You may not change your plan while you have an open position.

Sirens were sea creatures of Greek myths who sang so beautifully that sailors jumped overboard and swam to them, only to be killed. When Odysseus wanted to hear the Sirens’ songs, he ordered his men to seal their ears with beeswax but to tie him to the mast. Odysseus heard the Sirens’ song but survived because he couldn’t jump overboard. You ensure your survival as a trader when on a clear day you tie yourself to the mast of a trading plan and money management rules.

A Positive Group

You don’t have to be a hermit—steering clear of the crowd’s impulsivity doesn’t mean you have to trade in total solitude. While some of us prefer doing it that way, intelligent and productive groups can exist. Their key feature has to be independent decision making.

This concept is clearly explained in a book, The Wisdom of Crowds, by a financialjournalist James Surowiecki. He acknowledges that members of most groups constantly influence one another, creating waves of shared feelings and actions. A smart group is different: all members make independent decisions without knowing what others are doing. Instead of impacting each other and creating emotional waves, members of an intelligent group benefit from combining their knowledge and expertise. The function of a group leader is to maintain this structure and to bring individual decisions up for a vote.

In 2004, a year prior to reading The Wisdom of Crowds, I organized a group of traders along those lines. I continue to manage it with my friend Kerry Lovvorn—the SpikeTrade group.

We run a trading competition, with each round lasting one week. After the market closes on Friday, the stock picks section of the website becomes closed to viewing by members until 3 p.m. on Sunday. During that time, any group member may submit one favorite pick for the week ahead—without knowing what other group members are doing. The picks section of the website re-opens on Sunday afternoon, allowing all members to see all picks. The race begins on Monday and ends on Friday, with prizes to winners.

Throughout the week members exchange comments and answer questions. The site is built to encourage communication—except for weekends, when everyone must work independently. The results of leading group members, posted on the site, have been spectacular.

The key point is that all decisions about stock selection and direction must be made in solitude, without seeing what the leaders or other members are doing. The sharing begins after all votes are in. This combination of independent decision making with sharing brings forth “the wisdom of crowds,” tapping the collective wisdom of the group and its leaders.

Psychology of Trends

Each price represents a momentary consensus of value among market participants. Each tick reflects the latest vote on the value of a trading vehicle. Any trader can “put in his two cents worth” by giving an order to buy or sell, or by refusing to trade at the current level.

Each price bar or candle reflects a battle between bulls and bears. When buyers feel strongly bullish, they buy more eagerly and push markets up. When sellers feel strongly bearish, they sell more actively and push markets down.

Charts are a window into mass psychology. When you analyze charts, you analyze the behavior of trading masses. Technical indicators help make this analysis more objective. Technical analysis is for-profit social psychology.

Strong Feelings

Ask a trader why prices went up, and you’ll probably get a stock answer—more buyers than sellers. This isn’t true. The number of shares or futures contracts bought and sold in any market is always equal.

If you want to buy 100 shares of Google, someone has to sell them to you. If you want to sell 200 shares of Amazon, someone has to buy them from you. This is why the number of shares bought and sold is equal in the stock market. Furthermore, the number of long and short positions in the futures markets is always equal. Pricesmove up or down not because of different numbers but because of changes in the intensity of greed and fear among buyers and sellers.

When the trend is up, bulls feel optimistic and don’t mind paying up. They buy high because they expect prices to rise even higher. Bears feel afraid in an uptrend, and they agree to sell only at a higher price. When greedy and optimistic bulls meet fearful and defensive bears, the market rallies. The stronger their feelings, the sharper the rally. The rally ends only when bulls start losing their enthusiasm.

When prices slide, bears feel optimistic and don’t quibble about selling short at lower prices. Bulls are fearful and agree to buy only at a discount. While bears feel like winners, they continue to sell at lower prices, and the downtrend continues. It ends when bears start feeling cautious and refuse to sell at lower prices.

Rallies and Declines

Few traders are purely rational human beings. There is a great deal of emotion in the markets. Most participants act on the principle of “monkey see, monkey do.” The waves of fear and greed sweep up bulls and bears.

The sharpness of any rally depends on how traders feel. If buyers feel just a little stronger than sellers, the market rises slowly. When they feel much stronger than sellers, the market rises fast. It is the job of a technical analyst to find when buyers are strong and when they start running out of steam.

Short sellers feel trapped by rising markets, as their profits melt and turn into losses. When short sellers rush to cover, a rally can become parabolic. Fear is a much stronger emotion than greed. Rallies driven by short covering are especially sharp, although they do not last very long.

Markets fall because of fear among bulls and greed among bears. Normally bears prefer to sell short on rallies, but if they expect to make a lot of money on a decline, they don’t mind shorting on the way down. Fearful buyers agree to buy only below the market. As long as short sellers are willing to meet those demands and sell at a bid, the decline will continue.

As bulls’ profits melt and turn into losses, they panic and sell at almost any price. They are so eager to get out that they hit the bids under the market. Markets can drop fast when hit by panic selling.

Price Shocks

Loyalty to the leader is the glue that holds groups together. Group members expect leaders to inspire and reward them when they are good but punish them when they are bad. Some leaders are very authoritarian, others quite democratic and informal, but every group has a leader—a leaderless group can’t exist. Price functions as the leader of the market crowd.

Winners feel rewarded when price moves in their favor, and losers feel punished when it moves against them. Crowd members remain blissfully unaware that by focusing on price they create their own leader. Traders who feel mesmerized by prices create their own idols.

When the trend is up, bulls feel rewarded by a bountiful parent. The longer an uptrend lasts, the more confident they feel. When a child’s behavior is rewarded, he continues to do what he did. When bulls make money, they add to long positions. While new bulls enter the market, bears feel they are being punished for selling short. Many of them cover shorts, go long, and join the bulls.

Buying by happy bulls and covering by fearful bears pushes uptrends higher. Buyers feel rewarded, while sellers feel punished. Both feel emotionally involved, but few traders realize that they are creating the uptrend and setting up their own leader.

Eventually a price shock occurs—a major sale hits the market, and there aren’t enough buyers to absorb it. The uptrend takes a dive. Bulls feel mistreated, like children whose father slapped them during a meal, but bears feel encouraged.

A price shock plants the seeds of an uptrend’s reversal. Even if the market recovers and reaches a new high, bulls feel more skittish and bears become bolder. This lack of cohesion in the dominant group and growing optimism among its opponents makes the uptrend ready to reverse. Several technical indicators identify tops by tracing a pattern called bearish divergence. It occurs when prices reach a new high but the indicator reaches a lower high than it did on the previous rally. Bearish divergences mark the ends of uptrends and some of the best shorting opportunities.

When the trend is down, bears feel like good children, praised and rewarded for being smart. They feel increasingly confident, add to short positions, and the down trend continues. New bears come into the market. People admire winners, and the financial media keeps interviewing bears during bear markets.

Bulls lose money in downtrends, making them feel bad. They start dumping their positions, and some of them switch sides to join bears. Their selling pushes markets lower. 

After a while, bears grow confident and bulls feel demoralized. Suddenly, a price shock occurs. A cluster of buy orders soaks up all available sell orders and lifts the market. Now bears feel like children whose father has lashed out at them in the midst of a happy meal.

A price shock plants the seeds of a downtrend’s eventual reversal because bears become more fearful and bulls grow bolder. When a child begins to doubt that Santa Claus exists, he’ll seldom believe in Santa again. Even if bears recover and prices fall to a new low, several technical indicators will help identify their weakness by tracing a pattern called a bullish divergence. It occurs when prices fall to a new low but an indicator traces a shallower bottom than during the previous decline. Bullish divergences identify some of the best buying opportunities.

Social Psychology

Free will makes individual behavior hard to predict. Group behavior is more primitive and easier to track. When you analyze markets, you analyze group behavior. You need to identify the direction in which groups are running and their changes of speed.

Groups suck us in and cloud our judgment. The problem for most analysts is that they get caught in the emotional pull of the groups they try to analyze.

The longer a rally continues, the more analysts get caught up in mass bullishness, ignore danger signs, and miss the eventual reversal. The longer a decline goes on, the more analysts get caught up in bearish gloom and ignore bullish signs. This is why it helps to have a written plan for analyzing markets. We have to decide in advance what indicators we will watch, how we will interpret them, and how we’ll act.

Professionals use several tools for tracking the intensity of the crowd’s feelings. They watch the crowd’s ability to break through recent support and resistance levels. Floor traders used to listen to the changes in pitch and volume of the roar on the exchange floor. With floor trading rapidly receding into history, you’ll need special tools for analyzing crowd behavior. Fortunately, your charts and indicators reflect mass psychology in action. A technical analyst is an applied social psychologist, usually armed with a computer.

Managing versus Forecasting

I once ran into a very fat surgeon at a seminar. He told me that he had lost a quarter of a million dollars in three years trading stocks and options. When I asked him how he made his trading decisions, he sheepishly pointed to his ample gut. He gambled on hunches and used his professional income to support his habit. There are two alternatives to “gut feel”: One is fundamental analysis; the other is technical analysis.

Fundamental analysts study the actions of the Federal Reserve, follow earnings reports, examine crop reports, and so on. Major bull and bear markets reflect fundamental changes in supply and demand. Still, even if you know those factors, you can lose money trading if you are out of touch with intermediate- and short-term trends, which depend on the crowd’s emotions.

Technical analysts believe that prices reflect everything known about the market, including fundamental factors. Each price represents the consensus of value of all market participants—large commercial interests and small speculators, fundamental researchers and technicians, insiders and gamblers.

Technical analysis is a study of mass psychology. It is partly a science and partly an art. Technicians use many scientific methods, including mathematical concepts of game theory, probabilities, and so on. They use computers to track indicators.

Technical analysis is also an art. The bars or candles on our charts coalesce into patterns and formations. The movement of prices and indicators produces a sense of flow and rhythm, a feeling of tension and beauty that helps us sense what is happening and how to trade.

Individual behavior is complex, diverse, and difficult to predict. Group behavior is primitive. Technicians study the behavior patterns of market crowds. They trade when they recognize patterns that preceded previous market moves.

Poll-Taking

Politicians want to know their chances of being elected or re-elected. They make promises to voters and have poll-takers measure a crowd’s response. Technical analysis is similar to political poll-taking, as both aim to read the intentions of masses.

Poll-takers do it to help their clients win elections, while technicians do it for financial gain. Poll-takers use scientific methods: statistics, sampling procedures, and so on. They also need a flair for interviewing and phrasing questions; they have to be plugged into the emotional undercurrents of their party. Poll-taking is a combination of science and art. If a poll-taker says he is a scientist, ask him why every major political polltaker in the United States is affiliated with either the Democratic or Republican party. True science knows no party.

A market technician must rise above party affiliation. Be neither a bull nor a bear, but only seek the truth. A biased bull looks at a chart and says, “Where can I buy?” A biased bear looks at the same chart and tries to find where he can go short. A top-flight analyst is free of bullish or bearish biases.

There is a trick to help you detect your bias. If you want to buy, turn your chart upside down and see whether it looks like a sell. If it still looks like a buy after you flip it, then you have to work on getting a bullish bias out of your system. If both charts look like a sell, then you have to work on purging a bearish bias.

A Crystal Ball

Many traders believe that their aim is to forecast future prices. The amateurs in most fields ask for forecasts, while professionals simply manage information and make decisions based on probabilities. Take medicine, for example. A patient is brought to an emergency room with a knife wound—and the anxious family members have only two questions: “will he survive?” and “when can he go home?” They ask the doctor for a forecast.

But the doctor isn’t forecasting—he is managing problems as they emerge. His first job is to prevent the patient from dying from shock, and so he gives him painkillers and starts an intravenous drip to replace lost blood. Then he sutures damaged organs. After that, he has to watch against infection. He monitors the trend of the patient’s health and takes measures to prevent complications. He is managing—not forecasting. When a family begs for a forecast, he may give it to them, but its practical value is low.

To make money trading, you don’t need to forecast the future. You have to extract information from the market and find out whether bulls or bears are in control. You need to measure the strength of the dominant market group and decide how likely the current trend is to continue. You need to practice conservative money management aimed at long-term survival and profit accumulation. You must observe how your mind works and avoid slipping into greed or fear. A trader who does all of this will succeed ahead of any forecaster.

Read the Market, Manage Yourself

A tremendous volume of information pours out of the markets during trading hours. Changing prices reflect the battles of bulls and bears. Your job is to analyze this information and bet on the dominant market group.

Whenever I hear a dramatic forecast, my first thought is “a marketing gimmick.” Advisors issue them to attract attention in order to raise money or sell services. Good calls attract paying customers, while bad calls are quickly forgotten. My phone rang while I was writing the first draft. A famous guru, down on his luck, told me that he had identified a “once-in-a-lifetime buying opportunity” in corn. He asked me to raise money for him and promised to multiply it a hundred-fold in six months! I do not know how many fools he hooked, but dramatic forecasts have always been good for fleecing the public. Most people do not change. While working on this update 21 years later, I read in The Wall Street Journal that this same “guru” was recently punished for professional misconduct by the National Futures Association.

Use common sense in analyzing markets. When some new development puzzles you, compare it to life outside the markets. For example, indicators may give you buy signals in two markets. Should you buy the one that declined a lot before the buy signal or the one that declined a little? Compare this to what happens to a man after a fall. If he falls down a few steps, he may dust himself off and run up again. But if he falls out of a second-story window, he’s not going to run anytime soon; he needs time to recover.

Successful trading stands on three pillars. You need to analyze the balance of power between bulls and bears. You need to practice good money management. You need personal discipline to follow your trading plan and avoid getting high or depressed in the markets.

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