Perception vs Reality - Trade What is Real, Not What You Feel, Part Two
Perception vs Reality - Trade What is Real, Not What You Feel, Part Two
To read part one of this article, click here.
The Reality:
The area labeled "XLT Demand" on the chart represents an objective demand price level. We know this because price rallies strong from this level among other Online Trading Academy rules for identifying demand and supply levels. The area labeled "XLT Buys" represents the time when Online Trading academy Extended Learning Track (XLT) members were buying shares of BP. The news of the Gulf spill was very real, very bad, very awful and prices fell. However, once they reached the level where there was objectively more demand than supply, prices turned higher. This gave us our low risk, high reward, and high probability buying opportunity.
The Lesson: Strong news actually creates powerful turns in the market, opposite of what the majority expects because one side (buyers or sellers) exhausts itself into a price level where objectively, supply or demand are out-of-balance.
Fundamental Analysis
The Illusion:
In some cases, such as the chart of Intel Corp. (INTC) below, there are a number of illusions at work at once, severely clouding reality. INTC is a technology stock most people are familiar with. The rally in price in INTC, as the stock revisits the area of imbalance, is accompanied by great news on earnings. A strong "uptrend" in price is seen as well. The illusions here are many and create strong beliefs that lead to everyone buying in this case. These beliefs lead to action (buy or sell) and this action (buying and selling) is all we need to be concerned with. No matter who or what is telling us to buy the stock and why, all we need to know is this: Are prices at a level where there is objectively more demand than supply? If the answer is no, there is no reason to buy.
Not only is the answer no at the time of the earnings announcement, but the laws of supply and demand tell us we should be selling here, not buying. This earnings report, which invited the masses to buy, is given right into an objective supply area where the chart suggests supply exceeds demand. The eventual drop in price from this level is fast and strong for one simple reason. The number of willing buyers at this supply level became zero, while the number of willing sellers was still significant (supply/demand imbalance). The picture below was taken during a live trading and analysis session for Online Trading Academy graduates as I was setting up a short position with them and for them. All this is information was available to us months prior to the rally and great earnings report. But most market participants didn't see it or care, as the illusions were too strong. Adding to the illusion was the uptrend, the higher prices advanced, the more people desired to buy into it. We are humans: There is comfort and safety in numbers.
"Last night, Intel (NASDAQ: INTC) said quarterly earnings quadrupled to 43 cents per share, topping the consensus view of 38 cents per share. Revenue rose 44% to trump forecasts as technology spending has increased among consumers and corporations." - AP
Live Online Trading Session ñ April 15th
INTC Reaches Profit Targets
Again, many illusions come into play in this example. The illusion-based trader saw a low risk/high reward buying opportunity at the supply level, while at the same time, the reality-based trader (us) saw that same opportunity as a low risk/high reward shorting opportunity.
The Reality:
The objective supply (resistance) area is labeled as such because it is a price level where supply and demand is out-of-balance. Put simply, there is too much supply. Again, prices can only drop from that area because there are more willing and able sellers than buyers, there can be no other reason for the decline in price on the left. Objectively, the worst possible action to take is to buy anywhere near this supply area, especially on the first rally into it, which is when we sold short. Many illusions, however, invite the masses to buy at the absolute worst time and there is a reason for this...
The Lesson: When perceived risk is lowest, actual risk is often highest. When perceived risk is highest, actual risk is often lowest.
Illusion: Everything in the company is good; therefore, the stock is a quality investment.
Most people require specific criteria in order to feel comfortable buying a stock. These criteria likely include:
Buying High?
When all of the criteria here are true, where do you think the price of the stock is? If you said "high," you are correct most of the time. If you buy when everyone else is taught to buy and when the stock price is high, who is going to buy from you? Remember, the only way you can derive a profit from an investment or trade is when someone buys from you at a higher price than what you paid. This is no different than buying and selling anything, which includes real estate, automobiles, computer, groceries, and much more. Would you ever offer to pay a higher price than the car dealer was asking? Of course not. Yet when your favorite car is on sale for half price, I bet you will buy it as fast as you can. This is the exact opposite action that most people take in the markets when putting their hard-earned money at risk.
The many illusions are nothing more than risk disguised as opportunity. Falling prey to a variety of market illusions makes it possible to disguise irrational behavior as "safe," "proper," or "accepted." An illusion is an erroneous perception of reality. Illusions lead the average trader and investor to commit two consistent mistakes:
ï Buying after a period of rising prices;
ï Buying at a price level where we objectively, willing supply exceeds willing demand.
Both of these actions are completely inversely related to how you profit when buying and selling anything. They go completely against the laws of supply and demand. However, we don't want illusion based traders and investors to go away. Why? We need them on the other side of our trades. In short, the reality-based trader typically derives his or her profit from the actions of the mass illusion-based crowd.
Act Like A Goose
The human mind is not wired to trade properly. Our decision-making process is not like most other animals. Most people don't focus on reality when deciding to take action; we make decisions based on emotion, not intellect. Not only is it very difficult to live in complete reality, but consistently making actions based on reality is an even harder task many times. A goose, on the other hand, would make an excellent trader and investor. When autumn approaches in the north, the geese don't wonder if winter will come or not. They certainly don't call a goose meeting to figure out a way to stave off winter. They simply act like a machine and fly south for the winter and repeat this process each and every year flawlessly for their entire life, without questioning their choice.
Throughout history, people that pioneered original reality-based thought on certain topics often paid for it with their life. An example that comes to mind was the crazy thought that the world was round. Though your life is certainly not in jeopardy with illusion-based trading and investing, the growth of your hard-earned capital sure is.
The Three Laws of Price Movement
I have been involved with trading and investing for more than ten years, and the consistent low risk profits I have produced are a function of trading what is real, not what I feel. I eliminate subjective emotions by basing each and every decision on a simple mechanical set of objective rules that quantify supply and demand. These simple rules, which are beyond the scope of this article, stem from three laws of price movement I crafted long ago. These three laws form the foundation upon which the whole system of proper trading and investing lie.
Laws of Price Movement:
- Price movement, in any free market, is only a function of an ongoing supply and demand relationship within that market.
- Any and all influences on price are reflected in price.
- The origin of motion/change in price is an equation where one of two competing forces (buyers and sellers) becomes zero at a specific price.
Hope this was helpful. Have a great day.
- Sam Seiden
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About Sam Seiden
Sam brings over 15 years experience of equities, forex, options and futures trading which began when he was on the floor of the Chicago Mercantile Exchange where he facilitated institutional orderflow. He has traded equities, futures, interest rate markets, forex, options, and commodities for his personal interests for years and has educated hundreds of traders and investors through seminars and daily advisory services both domestically and internationally. Sam has been involved in the markets since 1991 both on and off the floor of the Chicago Mercantile Exchange. He has served as the Director of Technical Research for two trading firms and regularly contributes articles to industry publications. Sam is known for his trading, technical research, and educational guidance.
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