A successful self trader – Rule # 29
All your trading strategies should be based on this premise! It does not matter if the price on the screen is logical or illogical. It also does not matter if your reasoning sounds more logical than the market. For a trader, there is no greater truth than the tape. As long as you build your strategy around this premise, you are more likely to end up on the winning side. Else, you end up on the losing side.
NEVER QUESTION THE WISDOM OF THE MARKETS
Well, it happens so often to all of us. A perfectly executed trade backed by mountains of data and back testing and a very sound logic, simply goes kaput. You are shocked that the market is behaving irrationally enough to disprove your eminently enticing logic. As a trader the first reality you need to submit to is that, for better or for worse, “The stock market is always right”.
A stock trader came up to me in 2005 and complained that despite his best efforts and research, he was losing money in the market. Digging a little deeper, we realized that in a market that was in the midst of a gripping bull run, he was consistently trying to short sell the market. He was not wrong. All indicators were pointing towards a correction, but that was just not coming.
Fortunately, the above story had a happy ending. We advised him to just listen to the market, assume the market is right and start trading all over again. He turned long on the market and by the time his stop losses started hitting in late 2005, he had made enough money to cover his stop losses. So what changed? Nothing; except the admission that the market is the king of the trading game, and it is foolish to try and argue with the market.
WHY DO MARKETS DEFY LOGIC?
LOGIC IS ALWAYS RELATIVE
What many of us often believe to be logical, in our opinion, tends to be affected by incomplete data or wrong judgment. Logic, as we define it, is always relative. Ironically, when we go wrong, we tend to blame the market for being illogical.
LIQUIDITY, NOT LOGIC, DRIVES MARKETS
This is where a trader needs to think differently from an investor. If relentless liquidity is driving the market, the trader needs to play on the side of the market. The momentum of money is always more potent than the gravity of logic.
MARKETS TEST IRRATIONALITY TO THE LIMITS
Remember the famous words of Keynes, “Markets can be irrational longer than you and I can be solvent”. This is a golden rule for a trader. Don’t blame the irrationality. Assume that it will be stretched to its limit in both the directions.
“What matters for a trader is how much money he makes when he is right and how much he loses when he is wrong” – George Soros
WHY BELIEVE THAT THE STOCK MARKET IS ALWAYS RIGHT
- As a trader, the basic rule is that the trend is your friend. A long term investor has the luxury of indulging in more esoteric activities like buy-and-hold, contrarian investing etc. As a trader, your target is to be right more often than you are wrong. And that is possible, only if you stay in sync with the market.
- A stock market is the best approximation of mass psychology. It includes the expectations, illusions, whims and the fantasies of millions of investors. It hardly matter whether the market is right or wrong. What matters is that it is the closest proxy for what millions of investors are thinking and feeling.
- The biggest danger in trading is the notion that your strategy and market philosophy is more potent than the stark reality of the market. That is doomsday for the trader. A trading strategy driven more by your own notions of the market is designed to fail. Better be humble to accept the market reality.
- Markets typically give 3 kinds of signals for the discerning investors. It either indicates that more people want to buy, or more people want to sell, or that more people are confused about the direction of the market. Either ways, once you understand this signal, your trading strategy becomes a cakewalk.
- Institutional investors add a lot of fundamental and directional flavour to the market. The market is where large institutional investors like pension funds, endowments, and sovereign funds with huge stakes are allocating their monies. Their collective wisdom adds a lot of intelligence to Mr. Market.
- As a trader, you always trade with finite capital, never with an endless source of funds. Your primary challenge is, therefore, to conserve your capital and keep losing trades to the minimum. The more you tune your trading strategy to market signals, the more successful you are likely to be as a trader.
THREE WISDOMS OF THE MARKET
There are 3 kinds of wisdom that the market offers. Firstly, the combination of price and volume momentum gives you a clear indication of when you need to be long on the market. Secondly, the combination of a weakening price chart and negative volumes indicates when you must be short in the market. A smart trader is one who is able to read these indicators and translate them into a trading decision.
The third, and probably, the most important indication that the market gives is when you should sit tight and do nothing. Typically, when the market signals are very confusing or when the markets indicate high volatility with an uncertain direction, the signal is to sit on cash and not try to outsmart the market. Trading is as much about doing nothing as it is about buying and selling. In fact, the most critical decision for any trader is when to sit tight and do nothing. Only the market can indicate that.
TAKEAWAYS FROM THE “MARKET IS ALWAYS RIGHT” DEBATE
The debate on “Whether the market is always right” has traditionally been a bone of contention between traders and investors. Of course, the veracity of this statement largely depends on whether you are a short term trader or a long term investor. As a long term investor, it makes sense for you to worry about the extent to which equity fundamentals are divorced from stock market prices. The value for an investor comes from identifying and capitalizing on this gap.
As the legendary investor, Jesse Livermore said, “There may be two sides to everything in this world, but to the stock market there is only side and that is the right side” As long as you are able to be long in a rising market and short in a falling market, you will make money as a trader. The secret is not about charts or pivots or values. The secret is about accepting that what the market indicates is more important that what you believe. That is the day you start being a good trader, at least on paper.
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