The Psychology of Trading and Investing

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The Psychology of Trading and Investing

Trading psychology is a subject most books and so-called professionals keep separate from the mechanics and strategies of trading and investing. A reality largely misunderstood is that the underlying mechanics and strategies within trading and investing are a direct function of your psychological belief system. At any given time in the stock market, there are buy and sell invitations sent out in the form of news events, technical indicators, earnings reports, company announcements, brokerage upgrades and downgrades, and much more. These invitations are then received by the belief systems of tens of millions of traders and investors worldwide. What separates the consistently profitable market player from everyone else is a psychological belief system that filters all these invitations to buy and sell through the market's ongoing supply (resistance) and demand (support) relationship. When this is done properly, you will quickly realize, for example, that often, a buy recommendation from a brokerage firm and/or a good earnings report from a company do not equate to market demand or higher prices for the company's stock. Conversely, negative news or a brokerage downgrade may actually lead to a low risk / high reward buying opportunity. Some of the most common and popular invitations to buy and sell occur with stocks. Providing awareness of the various buy and sell invitations for stocks, demonstrating how to mechanically filter these invitations through the stock market's true supply and demand equation, and providing rule-based tools for taking advantage of these frequent traps and opportunities is the focus of this article.

A psychological belief system that enjoys consistent low risk / high reward profits is one that identifies and accepts an invitation to buy into a market when objectively, market price is at a level where demand greatly exceeds supply. A belief system that suffers consistent poor results is one that identifies and accepts an invitation to buy into a market when objectively, price is at a level where supply exceeds demand. There are two types of buy and sell invitations. The first are the market's buy and sell invitations which are based only on the irrefutable governing dynamics of supply and demand. The second includes everything from good and bad news to positive and negative earnings reports, to brokerage upgrades and downgrades and many more. The first has you focus on reality while the second has you focus on everything but reality, and that is a trap.

US Equities Rally Up on Yuan Intervention
Mon, Jun 21 2010, 14:18 GMT
(Barcelona) - US benchmark indices tracked the wide-spread positive tone seen in financial markets, as investors embarked upon a quest for higher yielding corners across the market place. The aggressive shift targeting upside levels is primarily attributed to the PBoC's vow to unpeg tight oscillations between the Renminbi and the US Dollar. The investing community rose its global outlook on the basis that the action taken by Chinese's officials will likely rise demand for exports and commodities. The Dow Jones Industrial Average logged in substantial gains through the first hour of trading as the index jumped above 1.30%. The Nasdaq Composite surged by more than 1% while the S&P 500 rose by 1.50%.

For example, China announced positive news recently regarding the unpegging of its currency as seen in the news release above. That morning, as the news came out, global stock markets like the S&P above rallied strong, gapping up as much as 1.5% on the news. The moment this "positive buying invitation" into the stock market was delivered to your belief system through your television screen or the news feed on your computer, there are two questions you can ask yourself.

First: What did the news suggest I should do? In this case, whatever the details of the news are, the release of it pushes the positive button in your brain and most people will be invited to buy.

Second: What would a consistently profitable buyer and seller of anything do at this price based on the irrefutable laws of supply and demand? When we objectively assess the market's supply and demand equation after the news was released and price gapped up, the invitation sent to the reality-based belief system is to do nothing or sell, not buy.

Notice the price action near the top of the chart. A couple of times, price is basing, sideways but can't stay at those levels and declines. The only thing that can cause the drop in price is more willing supply than demand. Therefore, when price revisits the supply level marked on the chart where the short entry was taken, we know two things: First, the buyers, at the point I shorted, are buying after a significant advance in price. Second, they are buying at a price level where supply exceeds demand. A consistently profitable buyer and seller of anything would never make these two mistakes. If they did, they would not be consistently profitable. The laws of supply and demand ensure that the buyer who buys after a period of buying, and at price levels where supply exceeds demand, will consistently lose their capital over time.

Had you taken the news event as an invitation to buy, you would have let illusion distort the reality that is always right in front of you, and losses, or drawdowns, to your hard-earned capital would have followed. Had you filtered that invitation through the laws of supply and demand, you would have been a seller like I was.

Why would that novice buyer make such an obvious mistake? Simple, the belief system that drives their behavior/action is flawed. When you understand that your psychological belief system IS your trading and/or investing strategy, you will realize how important it is to align your belief system with reality. You are essentially searching for truth so beware of illusion. The addition of even the slightest amount of illusion into your belief system ensures truth will never be found.

Often, the focus of poor trading and investing results is a lack of discipline when attempting to follow the rules of a strategy. What keeps people from not following rules is typically not a lack of discipline, it is because their invitations to buy and sell are not in line with their psychological belief system. There is internal conflict when it is time to take action. Don't punish yourself for not acting when the market calls you to action. Instead, take a step out of the box that is your belief system and make sure it is only filled with objective information and reality.

Any and all influences on price are reflected in price.

All the news and market information is filtered through your belief system. Your belief system is responsible for the thoughts and perceptions created from the news and information. Every thought and perception leads to ACTION and in trading and investing, action is either buying or selling. Therefore, all the consistently profitable trader or investor needs to focus on is price. Whatever the news and information for the stock is, your belief system MUST filter that information through a filter that quantifies the market's TRUE supply and demand relationship before a perception is created and action is taken. This will ensure you will not fall into the trap that the buyers of the S&P did. It will also allow you to profit from the many that consistently fall into that trap.

Once you understand that any and all influences on price are reflected in price at the level of your belief system, you next step is to know what true supply and demand looks like on a price chart. If you're not careful on this step, illusion can again creep into the equation if you let it. If you think the conventional technical analysis definitions of support and resistance are the answer, think again. A cluster of trading activity above and below current price is not necessarily true supply and demand. There is a very unique and simple chart pattern that represents peak demand and peak supply. While the details of this are beyond the scope of this article, the chart examples I have provided should help guide the way. Once you are able to identify true supply and demand on a price chart, simply follow these two rules:

1.    A negative news event, or negative stock market information, which brings price to a level of fresh demand is typically an opportunity to buy, not sell.
2.    A positive news event, or positive stock market information, which brings price to a level of fresh supply is typically an opportunity to sell, not buy.

To be continued in part two.
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