Frank Kollar of FibTimer.com explains why trying to catch tops and bottoms is a fool's game, and why trading with trends is the only way to make money consistently in this business.
Humans are born with basic instincts for survival. They need to protect themselves at all costs. Certain critical instincts are inborn, such as hunger, self-survival, etc.
But humans are complex creatures. We also have learned instincts, habitual ways of behaving that are so automatic and unconscious that they seem as if they are part of our very fabric.
Acting Without Thinking Logically
For example, as you drive in traffic, you "instinctively" slow down or change lanes when the car in front of you seems to be driving erratically. You may have noticed that many drivers will make the lane change to avoid slowing down, and will even speed up to pass to take advantage of everyone else slowing down.
People react instinctively. Some act without thinking logically about their options, and without taking steps to avoid possible danger. They often tend to make poor decisions. Behavioral economists have demonstrated that people also make automatic, unconscious decisions when trading the markets.
Most people are extremely risk averse. They enjoy the pleasure of a sure win, even a small one, but try to avoid the pain of losses at all costs. Yet there is no logical reason to show such an asymmetry regarding their decision making.
Investors also sell their winning trades prematurely so they can lock in their profits. These unconscious and automatic decisions reflect a strong and universal human desire to avoid risk.
All of my strategies are non-discretionary. Emotions do not play a part in our buy or sell decisions. Our strategies offer disciplined execution of non-emotional buy and sell signals.
The reason for following any timing strategy is to remove yourself from making emotional trades, as well as to remove yourself from the herd, which is often headed in the wrong direction-toward the nearest cliff.
Playing it Safe
As humans socially evolved, they learned to protect their survival by playing it safe.
Playing it safe may be prudent for very long-term investors, but for shorter-term investors...those who are unhappy with the losses incurred during numerous inevitable downtrends, and who wish to avoid those losses or capitalize on the downtrends, fear of risk and uncertainty is an impediment to success.
It is necessary to identify this need for safety and security and "reprogram" yourself to work around it.
Following the Masses
A common illustration of risk aversion happens when market participants follow the masses, as if they are wild animals banding together as a herd for protection. They look toward others for direction, regardless of the consequences.
During a typical market correction, investors increase their selling the lower the market goes, with huge numbers of them selling near the bottom. The same thing happens in every decline. As more and more people see prices drop, more and more participants sell.
It is scary to see your investment values plummet. Is the news going to get worse? Will the prices reach even lower lows?
Most people are afraid of pain. They are afraid that the price may go even lower, and they sell because they don't want to lose even more money.
Of course, not all investors will sell. Some will become so panicked that they will be afraid to acknowledge their losses and want to leave them on paper, hoping that the prices will return to previous levels in the coming weeks. During a bear market, this can be an even worse decision.
The masses try to avoid risk and pain, and by doing so, they tend to behave automatically. Repeating the same actions time after time. Experienced market timers, in contrast, react more decisively. They carefully follow a trading strategy that is completely devoid of emotions. They follow through on buy and sell signals with absolute precision.
They know that any one or more buy or sell signals may be wrong, but they realize that to trade profitably, they must learn to trust their timing strategy and act on it. Only over time are substantial profits realized, and only by those market timers who stay the course.
Next: What you need to be a winning market timer|pagebreak|
If you want to be a winning market timer, you must learn to identify your need to follow the masses, and teach yourself to avoid doing what your need for security compels you to do. You must reprogram yourself to think outside the box. Rather than follow the masses, you must follow your timing strategy, which may be contrary to what most people would do. Over time, and with extensive experience, you will develop the skills that will allow you to trade decisively.
We have all seen the various headlines, ads, and marketing hype:
- "Use Japanese Candlesticks to spot reversals!"
- "Learn the secrets of the Pros!"
- "Learn when to take profits!"
- "Learn how to forecast reversals before they occur!"
The problem is that you cannot spot reversals or changes in trends until after they have occurred. No one can, although many profess to be able to do so. Those who profess to have the ability to call reversals and changes in trends "ahead of time," also expect you to believe they have the ability to "predict" the future.
After well over 20 years of market timing experience, please take our word for this: no one can predict, with any certainty or consistency, what the market is going to do. Of course, with so many analysts making predictions on a daily basis, someone will get a prediction right. But doing it consistently is something else again.
No one can predict, with any consistency, the future. All we can predict with any certainty is the markets will constantly change. So if there is no way to predict what the markets are going to do, how do we time the markets?
By trading the medium- to long-term trends that are inherent in free markets, and always will be. Based on hundreds of years of history, markets will usually be in an uptrend or a downtrend for sustained periods of time.
Look at any long term chart and it will be obvious. From that fact, a winning strategy can be created.
The Question of Time Frame
How do we establish that a trend has started?
Simply put, all we can depend on in the stock market is price. Price will change either up or down. Change is constant. If price moves higher for a sustained period of time, we are in an uptrend. If price moves lower for a sustained period of time, we are in a downtrend.
The question of time frame quickly enters here, as mutual-fund timers cannot, by definition, be daytraders. So a change in price to the upside lasting several hours-while it may be an uptrend to a very short-term trader-is useless for a fund timer. The time frame for fund timers is in weeks and months, with an emphasis on "months."
There is no way around it. If a fund timer trades more frequently, he or she will face a much larger percentage of losing trades, because the markets change so quickly from day to day that short-term trends are much harder to trade.
But remember what we said previously: history shows that trends do occur in the markets that last months and even years. In fact, the stock market is trending in measurable medium- to long-term trends about 80% of the time. Long-term trends are easy to see on historical charts. They can also be traded with a high degree of profitability, over time, by using trend trading strategies.
Next: We Aim for the Moon|pagebreak|
We Aim for the Moon
Trend traders do not try to catch exact tops. Nor do we try to catch exact bottoms. We do not believe that anyone can.
Of course, with hundreds of different opinions available at any time, someone will always be lucky and call an exact bottom or top. The financial news media is quick to go with the hype. But try and do it over and over and over.
So how do trend traders know when a trend has begun? The answer is... "after" it has started. Using prices, which are the only measurement of the markets that can "always" be depended upon, we can create specific trading rules that define when we are in a trend.
We could say that if the market rises a specific percentage from a low, we are in an uptrend. At that point, we can take a long, bullish position. But when do we exit? Do we exit after we have a 10% return? Or maybe set a goal of 20% and cross our fingers?
No. As trend timers, we aim for the moon. If a trend goes 200%, we want to be onboard from our entry point right to the 200% point. We want it all.
But, then how do we know when to exit? The answer is simple. We exit "after" the trend has ended, and not until then. That means we stay until "after" the trend reverses.
When we start the trade, we go in looking for a home run. The sky is the limit. We do not exit the trade until the market reverses and "prices" have moved far enough in the "opposite" direction to tell us a "new" trend has likely started.
That means we usually don't get in or out at any exact bottom. It also means we usually don't get in or out at any top. It means that sometimes we take small losses when our requirement is met for a new trend but the trend fails (and they do... remember the 20% of the time when the markets are not in a trend).
But most importantly, it means we "never miss" any substantial trends, and we ride every trend as far as it will take us! All identified trends are traded. All of them.
This is where market timers make their big profits. They do go through occasional boring sideways markets, but when the market does trend, they are "always" on board for the majority of that trend. By always going for the home run, trend traders, like baseball players, may have some strikeouts (small losses). But those strikeouts are obliterated by the home runs, which we ride for all they are worth.
In the aggressive strategies, we make money in both uptrends and downtrends. These are the strategies that score big during bear markets. But sometimes bear markets are far apart...this is where our active and conservative strategies do best. They go to cash (money market funds) during downtrends. And importantly in all our timing strategies, we cut our losses when a trend does not follow through.
Great fortunes are made trading trends. It takes a strategy. It takes discipline, because you must stick to the strategy in all market conditions, knowing that no one knows when the next trend will start.
But by trading trends, you know that over time you will beat the markets and be hugely profitable.
Frank Kollar can be found at FibTimer.com.