Matthew Kerkhoff, options expert and editor of Dow Theory Letters, continues his 14-part educational...
Three Illusions That Ruin Trading Accounts
11/25/2015 6:00 am EST
Earning consistent, low-risk profits from trading and investing is a challenge many millions of people take on, yet only a select few are ever able to succeed. The objective and mechanical rules for earning consistent, low-risk profits are very simple, yet the layers of illusion keep most from ever seeing what is real in trading and investing.
The two main forms of analysis in trading and investing are technical and fundamental analysis, and they are very real. However, thinking that mastering these two forms of "conventional" analysis will lead to consistent, low-risk profits is an illusion second to none. The more an individual attempts to master these types of analysis, the more they may be layering complex, subjective illusions on top of each other. This is a recipe for consistent failure.
What many beginning traders don't realize is that they are walking east and west near the equator while trying to reach the North Pole. No matter how hard they work, the goal they desire is not attainable as the path they are on is an illusion. Trading strategies that work don't change with time or changing market conditions. Quite frankly, to think market conditions ever change at all is a strong illusion that can only be removed when one focuses on the foundation principle of price movement, which is supply and demand. A simple and minor shift in perception to what is real can lead to a monumental shift in trading and investing performance.
The focus of this piece is to identify and remove the veil of illusion from trading and investing. How? By realizing that the movement of price in any market is based, at its core, on an ongoing supply/demand and human behavior relationship. We will quantify a supply/demand imbalance for objective opportunity in this article. As most traders are well aware, the overall goal is to decrease risk and increase profit potential. But many novice traders' strategies actually accomplish the opposite. Results for everyone from the active trader to the casual investor follow from taking various actions. Instead of focusing on changing our actions, it's time to notice where those actions come from.
Beliefs + Behavior Patterns = Actions
Let's move backward one step at a time. Actions stem from behavioral patterns, and behavioral patterns stem from beliefs. It is at the level of beliefs that decisions are made, and moreover, where your ability to differentiate reality from illusion lies. It's time to start considering where your beliefs come from regarding what works and what doesn't. The strongest illusions in the trading and investing world are found at the core of fundamental and technical analysis. Within these two forms of analysis lie many levels of illusion. In this piece, I will focus on three major illusions.
NEXT: The Moving Average Illusion|pagebreak|
1) The Moving Average Illusion
The chart below is a daily chart of the S&P 500, the biggest equity index market in the world. The information most people will perceive from this chart is an illusion that will likely lead to high-risk/low- reward trading and investing. The illusion here is that moving averages (MAs) somehow act as support or resistance. There are many conventional ways in which some traders use moving averages. These include using moving average crosses for entries and exits, measuring the slope of a MA for a "trend filter," or using a MA as support or resistance. However, the notion that MAs actually offer a benefit when used in these conventional ways is completely false; it is an illusion.
In this chart, both a 20- and 200-period moving average is seen. These are widely used moving averages both in the trading and investing communities. Notice the slope of the 20-period MA at the areas labeled "B." The slope of the 20-period moving average is down in both cases, suggesting a downtrend is underway. During this period, however, the low-risk/high-reward buying opportunity is greatest and right in front of you!
Those who use MAs as trend filters would never buy when the trend is down. This group of illusion-based traders and investors would likely conclude and say, "I don't want to buy now; the MA tells me this is a downtrend." The illusion created by using a MA to determine trend ensures you will ignore the lowest-risk/highest-reward opportunity each time it is offered. Furthermore, this illusion is likely to encourage a trader to take the opposite action of what the objective information (reality) suggests he or she should do.
Moving Averages Lag
MAs are averages of past data; they can only turn higher after price does. Let's focus in on the 200-day moving average. Specifically, notice area "B," which is below the 200-day MA. Most traders and investors either see the 200-day MA on a chart or hear about it from some financial news TV program. They perceive the mighty 200-day MA as some magical line that, when crossed, suggests some valuable information. As we can see, waiting for prices to rise above the 200-day MA before buying ensures three things. First, risk to buy is high, as one would be buying far from the demand level. Second, profit potential is decreased. Third, those who wait until prices have crossed back above the 200-day MA to buy will likely provide profit for the reality-based traders/investors who bought at "B," the low-risk/high-reward entry area. The objective supply/demand imbalance is at "B," and the 200-day MA has nothing to do with it. When a moving average lines up with true demand or supply, the moving average will appear to work. Believing that the moving average actually has anything to do with a turn in price is an illusion.
Let's now explore reality through the eyes of objective logic. The areas labeled "A" are objective demand (support) price levels. How can I claim they are objective demand price levels? Simple, while prices are trading sideways, supply and demand appear to be in balance. In both instances, prices rose dramatically from those areas. The only thing that can cause a price rally from that area is when the supply and demand equation is "out of balance." In other words, there was much more willing demand at "A" than supply. The laws of supply and demand simply tell us this is true.
The areas labeled "B" represent the first time prices revisit these two areas of "imbalance." In other words, prices have declined to an area where we objectively know there is more willing demand than supply. "B" is the low-risk/high-reward opportunity to buy. Buying in these two areas ensures three important things. First, your protective stop is small, which offers a trader proper risk management and position sizing. Second, your profit potential-which is the distance from the entry to the supply area above-is as large as it will ever be for this opportunity. In other words, as price moves higher from the objective demand level, it is moving closer to the supply level (target) above, decreasing your profit potential. Third, the probability of success is highest because supply and demand is very much out of balance at that level.
The Lesson: Indicators and oscillators are nothing more than a derivative of price and volume. Price is all that needs be considered when performing objective, reality-based analysis.
NEXT: The Trading on News Illusion|pagebreak|
2) The "Trading on News" Illusion
Below is a monthly chart of British Petroleum, or BP plc (BP). The 2010 Gulf oil spill disaster caused many to sell this stock, as this was one of the worst spills the world has ever seen. In our trading room, the Extended Learning Track (XLT), I suggested we buy BP shares for a longer-term hold at $27.00 because this was a strong demand level on the chart. The combination of a very negative news event and a quality buying opportunity brings us to our next illusion, the news.
The news illusion is the most powerful illusion in trading and investing because strong news leads to strong emotion (faulty beliefs). Most successful traders and investors have, at some point in their journey to consistent profits, fallen prey to this illusion. How many times have you seen bad news turn into a positive day for the markets? The news in the case of BP was very real and very bad:
"Associated Press - Thursday June 24th, 2010: BP shares fall to new low over Gulf spill. Worries over Gulf of Mexico oil spill push BP shares to new 52-week low in US. Shares of BP dropped to a new 52-week low in the US on Thursday, to levels not seen in 14 years, as the two-month-old oil spill in the Gulf of Mexico continues to weigh on the company's stock. BP lost 93 cents, or 3.1 percent, to close at $28.74. Shares dipped as low as $28.56 during the trading session. Analyst Phil Weiss of Argus Research said there didn't appear to be a particular reason for Thursday's decline. "There's still a lot of downward pressure on the shares, so, in general, I expect more down days than up days at least until the relief wells are successful or something else positive develops," he said."
The thought of a major oil spill led many to believe that prices would fall, and that belief drove the majority to sell. Once the last seller sells at a price level where willing demand exceeds willing supply ($27.00), the laws of supply and demand tell us prices rise.
The demand level labeled on the chart is the point in which prices move higher from the consolidation. Also, notice how strong that initial rally was. This suggests there was a big supply/demand imbalance in that level.
When price came back to that level the first time, many were selling because of that bad news. This offered us an opportunity to buy BP shares on sale, at the demand level. The news of the oil spill was very real, very bad, and prices fell. However, once they reached $27.00, where there was objectively more demand than supply, prices turned higher.
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 an objective supply or demand imbalance exists. In BP, bad news plus a collapse in price created a low-risk, high-reward buying opportunity. No matter how bad the news is, when the last seller sells at a price level where demand exceeds supply, prices rise. There can be no other mathematical outcome.
NEXT: The Fundamental Analysis Illusion|pagebreak|
3) The "Fundamental Analysis" Illusion
In some cases, such as the chart above, economic reports can severely cloud reality. This example shows the euro. The rally in price for the euro as the market reaches the area of supply (imbalance) is accompanied by a very good euro zone economic report. When price reached the supply level, I sold short, but to whom did I sell? I sold short to the buyer who bought after a rally in price, and into a price level where the chart already told me that supply exceeded demand. The odds are stacked against that buyer at supply who is buying because of the good news, which means the odds are stacked in my favor at that time, me being the seller. The illusion here creates strong beliefs, 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 is telling us to buy the euro and why, all we need to know is this: Are prices at a level where, objectively, there is more supply than demand? If the answer is yes, there is no reason to buy and every reason to sell.
All this information was available to us prior to the rally in price. But most market participants didn't see it, as the illusion of a strong euro zone economic report was too strong. Adding to the illusion was the uptrend in price; the stronger the uptrend, the more the herd-mentality people desired to buy into it. We are human, so there is comfort and safety in numbers. Again, trading is simply a transfer of accounts from the novice market speculator, who does not know what they are doing, into the account of someone who does. The illusion-based trader saw a high-risk/low-reward buying opportunity and took action to buy, while at the same time, the reality-based trader saw a low- risk/high-reward shorting opportunity and took action to sell.
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.
Illusion: Everything in the company is good; therefore, the stock is a quality investment.
When all of the news and reports are good, where do you think price is? If you said "high," you are correct most of the time. If you buy when everyone else is taught to buy and when 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, including real estate, automobiles, computers, and much more.
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 being "safe," "proper," or "accepted." An illusion is an erroneous perception of reality. Illusions lead the average trader and investor to commit two consistent mistakes:
- Buying after a period of rising prices
- Buying at a price level where we objectively know there are more willing sellers than buyers
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 because they consistently buy after the reality-based trader buys. In short, the reality-based trader typically derives his or her profits from the actions of the mass illusion-based crowd.
The argument I write about so often, exposing the glaring flaws of conventional technical analysis, is not all that different from the constant battle between those who follow the Austrian School of Economics and those who follow Keynesian principles. I, of course, clearly side with the Austrian School and try to show how to apply these principles in the MoneyShow.com articles I write.
A successful trader's path must be reality-based, not driven by illusion. The reality is that markets are nothing more than pure supply and demand at work-human beings reacting to the ongoing supply/demand relationship within a given market. This alone ultimately determines price. Opportunity emerges when this simple and straightforward relationship is "out of balance." When we treat the markets for what they really are and look at them from the perspective of an ongoing supply/demand relationship, identifying quality trading and investment opportunities is not that difficult a task.
By Sam Seiden, instructor, Online Trading Academy
Related Articles on STRATEGIES
Profit from a market by capturing a trend. Money management is key. The battle is often from within,...
Has Mr. Market (S&P 500/Equities) priced into too much positivity, while inflation remains at ba...
Berkshire Hathaway (BRK.B) is well known as the huge operating and investment company that was built...