In the third part of the Rules to Live and Trade by, we look at the role that psychology plays in the markets, why broad participation is preferable to narrowing market breadth and the nature of bear markets.
Fear and greed beat resolve. It's easy to make plans, but sticking to them is very hard
The biggest barrier to success that traders face is their own psychology and emotions, which can easily throw you off-course, despite you having the best of intentions.
Let that stop loss pass by without actioning it, and suddenly you are deep offside, one more position open won't hurt, and then the market turns against you, and you are running out of margin.
Trade in a bigger size than normal, it will be ok, until the market whipsaws and catches you out.
You can “talk yourself “ into all these errors and more. Greed and fear are deep-seated human emotions, and learning to overcome them doesn't happen overnight.
However, that process starts by recognising the effect that these emotions have on your thinking and actions. And once you have that under your belt, you can look out for them creeping into your decision-making, and take a metaphorical step back when they do.
Broad markets equal strength. When only a handful of stocks lead, it’s a warning
This might be the one rule that you could argue against as the Mag 7 and other technology stocks drive the markets higher, and you might reasonably argue that these are the stocks that are driving the new economy and that other stocks don't matter anymore.
But then again, that's what was being said by traders back in the dotcom boom, and look how that ended.
A concentration of risk, whether intended or not, is never a good idea, and diversification exists for a reason: to spread risk.
Yes, AI-related stocks are going great guns right now, with new deals being announced and double-digit percentage stock price rises becoming almost commonplace, but when you scratch the surface, most of the deals that are being done are being made between the Mag 7 names, the large chip makers and the AI operators.
Advanced Micro Devices AMD US rallied sharply after announcing a deal with OpenAI
Source: Barchart.com
Is it just me, or is all this dealmaking starting to look a bit incestuous?
Added to which we are not seeing other businesses or industries reaping the benefits from AI yet. I am not saying you should be bearish. But I am saying be aware, and wary of narrowing market breadth.
Bear markets have 3 stages: A sharp fall often followed by a reflexive rebound, and then a long, drawn-out downtrend.
If you are under the age of 30, then you probably won't have encountered a genuine bear market.
Yes, we had a sharp sell-off in March/April 2020 as COVID-19 took hold, but the recovery was equally swift, thanks to vaccines and the actions of central banks. So this wasn’t really anything like a traditional bear market.
Real bear markets are nasty and unforgiving; they often start with a panic as traders and investors all try to head for the exits at once.
This, in combination with limited liquidity (because nearly everyone is a seller), creates violent price swings.
Bear markets also have an unpleasant habit of sucking traders back in, with sharp, countertrend rallies that are often driven by bear closing /short covering and very little else.
The final stage of a bear market can often be a long, painful grind lower, as the market tries to find the equilibrium point/prices at which buyers can be tempted back.
However, in these circumstances, buyers are cautious. Many have had their fingers burnt and their capital greatly reduced by the sell-off.
In the bear market of 1973-1974, the FTSE 30 Index (the forerunner of the FTSE 100 ) lost -73.0% of its value.
When everyone agrees, you can expect the opposite to happen
Consensus might sound like a good thing, but it's not always the case in the markets, because if everyone is already bullish, then who is left to buy?
It's often said that it takes two views to make a market, and that’s very true.
We need buyers and sellers, bulls and bears, because it's the interaction between these two groups that keeps things ticking over.
Bubbles can form when one group (the bulls) have too much influence, which isn’t counterbalanced by traders with contrarian views.
You just have to think back to the surge in meme stocks, many of which were on the brink of bankruptcy, post-COVID, to get an idea of what this looks like.
Equally, we don't want bears ruling the roost unopposed either.
The majority view will always drive prices, particularly at the points where sentiment swings from equilibrium, to favour one side over the other.
It's also true to say that when the whole market is looking only one way, it can easily be blindsided by moves or data coming from the other direction.
You could argue that the GFC of 2007/08 was caused by this type of behaviour.
Bull markets are fun, bear markets are painful
Bull markets are enjoyable because people are making money, and that puts them in a good mood. Information and ideas flow freely, and you don't stress about meeting your commitments, paying your bills, topping up your pensions, funding your kids' education, etc.
“Everyone (who is long) looks smart when prices are rising”
On the other hand, bear markets are not much fun, and risk capital becomes scarce; assets are sold at discounted or rock-bottom prices.
Traders become fearful of being” topped and tailed” and become reluctant to take on new positions, particularly if they get caught up in bear market rallies that start and stop very abruptly.
If you go from a situation where you are making lots of money to one where you are making hardly any and have taken losses on the way down, your psychology changes, and you can become very defensive; in other words, fear overcomes greed.
But real fortunes can be made in bear markets if you go into them with your eyes open and sufficient resources to be able to exploit them.
Something that Warren Buffett has done so well over the years by buying good assets that have fallen to distressed prices, that are, for example, trading below book value, that is, a company whose share price is lower than the net asset value of the business.
There is a lot to think about in each of these articles, but if you can factor just some of this thinking into your trading process, you should feel the benefit.
The information provided does not constitute investment research. The material has not been prepared in accordance with the legal requirements designed to promote the independence of investment research and as such is to be considered to be a marketing communication.
All information has been prepared by ActivTrades (“AT”). The information does not contain a record of AT’s prices, or an offer of or solicitation for a transaction in any financial instrument. No representation or warranty is given as to the accuracy or completeness of this information.
Any material provided does not have regard to the specific investment objective and financial situation of any person who may receive it. Past performance is not a reliable indicator of future performance. AT provides an execution-only service. Consequently, any person acting on the information provided does so at their own risk. Forecasts are not guarantees. Rates may change. Political risk is unpredictable. Central bank actions may vary. Platforms’ tools do not guarantee success.