You May Have Been Fooled
You May Have Been Fooled
During our developmental years, we are taught/conditioned to think certain ways whether we realize it at the time or not. Our years in grammar school, high school and university are key belief system building years. One of the major conflicts during these years occurs when we are taught how to buy and sell in the financial markets and then how we are taught to buy and sell anything else in our life.
The basic principle of buying low and selling high or selling high and buying low is how we derive profit when buying and selling anything. When we buy cars or houses, we never offer what the dealer is asking. We always offer a lower price and typically end up somewhere in the middle. Smart shoppers look for deals where they can buy what they are looking for at a lower price than others pay. We all typically try or desire to buy at "wholesale" prices when buying anything and sell at "retail" prices when selling anything. At this point, you're probably thinking that I am wasting your time because you know this already and that's very true, you likely take this smart buying and selling action in every part of your life. However, during the years that we are conditioned to buy low and sell high, we are also taught to take the opposite buying and selling action when buying stocks for short-term trading and longer term investments.
For example, whether its advice from Wall Street or at every level in school, when we are taught to buy stocks as investments, we are told to wait for certain criteria to become true BEFORE we buy. These criteria include but are not limited to:
Conventional Criteria Needed Before Buying a Stock
1. Good company
2. Strong earnings
3. Healthy balance sheet
4. Quality management
5. Stock price trending up
6. Moving averages sloping higher
7. And so on...
When all these criteria are true, WHERE DO YOU THINK THE PRICE OF THE STOCK IS? It will almost always be high when these criteria are true which means you will likely be paying $50,000 for the $20,000 car and the seller is the big winner, not you. The way we are taught to buy stocks is completely opposite of how we are taught to buy and sell anything else. And therein lays the major conflict... A conflict that is single-handedly responsible for ruining the investment savings of tens if not hundreds of millions of hard working people around the world.
Recently during one of my live market trading sessions, I was going over the markets with hundreds of Online Trading Academy graduates and discussing this very issue. This was a timely topic because of where the stock market was and some key earnings released that quarter (Q2, 2011). Second quarter 2011 earnings were very strong. Just below are two big names and as you can see, they all easily beat analyst estimates.
There were fantastic earnings reports from Microsoft, Intel and many others, and as you can see from the chart below (circled area), many people bought the stock because of these strong earnings reports. Most of the criteria listed above were true with the stocks mentioned here and we are all taught to buy when this criteria is true so the strong rally and buying interest was no surprise. The only question that matters however is this: Should you be the buyer or the seller?
Price had powered higher for two years and continued with the great earnings news. However, when we look to the left, we see that price had reached the origin of a huge decline; we call this a supply (retail) level. How do we know that? When we keep things "real" and "objective," we understand that price originally declined from that level (shaded yellow) because supply exceeds demand, at that price level. Not only did it decline, but it declined in strong fashion suggesting a big supply and demand imbalance. Therefore, we then know that the buyers who are excited about buying with the strong earnings are making two mistakes that every losing market speculator makes. First, they are buying after a rally in price. Second, they are buying right into a price level where the chart is telling us, supply exceeds demand. Instead of focusing on what is "real," these buyers ignore the simple reality of how we make money buying and selling anything and buy at a time when price is most likely to fall.
During that live trading session, I made our graduates aware of the fact that price was at a level where it was likely to decline. We then planned out two things. First, the simple ways they could protect their gains in the equity markets with hedging. Second, we planned out a low risk, high reward and high probability shorting opportunity. Another very important piece of information we discussed was how far the decline in price was likely to be. Just because price was sitting at supply doesn't say anything to how far it will decline. For this information, we have to identify the nearest key "demand" (wholesale) level below. Keep in mind that I started my career on the trading floor of the Chicago Mercantile Exchange, now the biggest exchange in the world. I handled institutional order flow for a long time and one thing that was crystal clear is that the movement in price in any and all markets is simply a function of an ongoing, very quantifiable supply and demand equation. Price always turns at price levels where supply and demand are out-of-balance. All I am showing you here is exactly what that picture looks like on a price chart. The chart below clearly shows that the nearest "fresh" demand was significantly lower by hundreds of S&P points. While price did see intra-day bounces from higher demand levels, none met the true definition of demand that we have at Online Trading Academy. The fact that demand was so much lower meant the likelihood of a big decline in price was strong.
As you can see on the second chart, price eventually fell to our targets, but the most important thing to remember here is how to properly "think" the markets. Most people are so consumed with fundamental analysis and those strong earnings that they forget the simple fact of how you make money buying and selling anything. They forget the simple buying and selling action they take at the grocery store each week where they regularly try to buy low when items are on sale. The next time you are considering buying a stock as a trade or investment and all the criteria listed in this piece are true and the price of the stock is high, ask yourself one simple question: "If I buy the stock here, will someone buy it from me higher?" The price charts do an excellent job of answering this question for you; you just have to remember to ask the right question.
School is only one part of the problem. Wall Street is just as guilty. For example, when was the last time you heard someone from Wall Street suggest to buy a stock during a downtrend, when the news or earnings are bad? When your favorite item at the store was selling at $50.00 and has now gone on sale for $30.00, you are going to be very excited and probably buy more of that item than you normally would. But, what if we charted that decline in price; isn't the picture a downtrend? Every trading book on the planet says never buy in a downtrend. Like anything else in life, there is the "book" way of doing things and the "real world" way of how things work. Think of it this way... Most people around the world buy stocks. What is Wall Street's primary business? If you said selling stocks, you are correct. So, if everyone learns supply and demand and starts buying low and selling high like Wall Street does, who is Wall Street going to trade with? There is a reason why Wall Street frowns upon "market timing" which is what they are doing... The professionals say the average person can't time the market's turning points (Market Timing) in advance. As you can see in the example above, I say you can time the markets turning points in advance with a very high degree of accuracy.
Lastly, make sure you understand that when I am talking about Supply and Demand and Market Timing, I am not talking about conventional support and resistance that you read about in the trading books. In my humble opinion, that conventional school of thought is loaded with major flaws that lead people to buy high and sell low, not what you want to be doing unless you want to make Wall Street happy.
The next time someone offers you a stock with good earnings, in a strong uptrend, with great management, at a price level where the chart is telling you supply exceeds demand, think before you buy it. Don't be fooled by the illusion of value when the reality is that prices are at retail (supply) levels meaning the better deal is for the seller, not you.
Hope this was helpful. Have a great day.
- Sam Seiden
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