Sunday, March 16, 2008

"History teaches us..."

As you know, I don't commment on current market conditions on this blog. Being an educational blog, it's simply not the purpose. Being that, it would also be a crime not to comment on immense learning opportunity provided by the market conditions we are seeing.

Make no mistake, we are going through the crisis of historic proportions. It's almost time to start coining a name for it. Great Liquidity Crisis? Credit Crunch of the Century? The Day (insert bank name) Fell? If you as a trader went through this market unharmed - good job protecting your behind while sharks circle around. If you make money in this market - congratulations, you do not belong to majority anymore. If you are a newer trader just starting your quest - consider yourself very lucky. Yes, lucky, because if you learn in this environment - you will find the "normal" market to be piece of cake to trade in.

Let us outline the lessons to be learned during such extreme times.

First and foremost, and the most important:
1. Logic of underlying events vs. logic of market movement.
This is one of the most confusing aspects of the market for many investors and inexperienced traders. We are conditioned to see causes and outcomes as being linked in a logical fashion. Bad news should send the price down. Good news should cause rallies. We want to buy good news and short bad news. We want to trust our analysis and act on our conclusions - and we, naturally, expect the market to follow. So, shouldn't we feel perplexed seeing how the market stages stunning rally when there is nothing but doom and gloom in all the sources of information? What else can we do but dismiss it as manipulation?

Well, manipulation it is in many cases. However, this notion doesn't take us anywhere as far as money-making is concerned. The major lesson in this is old as the market itself: if something is exceedingly obvious, the market will act against it. Market by its very nature cannot reward the obvious with money - simply because majority follows the obvious, and majority cannot be profitable. It can't because there is no pool of money set aside for the winner - money is being extracted from other market participants. Who could majority extract the money from? And, if there is no money for a group betting on certain direction, then this group in fact renders this direction as wrong by simply being too big.

If this sounds confusing, let's put it in simpler terms. If there are just 10 participants in the market and 9 out of 10 bet on downward move, who is left to sell more and push the price lower? They all sold short already, so what are they going to do when they see that the price is not dropping anymore? What other choice do they have but to start closing their short positions, pushing the price higher? That single player that took long position against those 9 may be wrong about the events in economy - but he will be right on the market direction. He will make money by betting against majority. Of course this is simplified way to look at things, the reality is much more complex, with all the different timeframes, new participants jumping in or getting out. This simple case, however, explains the divergence between the logic of the market movement and the logic of economy events.

This is the major lesson of this market because rarely can it be seen as clearly as these days. Do not fall into the trap of obviousness. Being right in a long run will not protect you from the losses today. Being right about the meaning on events does not mean the market hasn't priced those events in yet. Alternatively, market may be preparing to move in your direction, and its way of preparation is to shake out prematurely taken positions. Market is doing its best to move having as few participants on board as possible - and it's doing it by means of moving against the obvious. Price action overrides everything. We traders profit from price changes - that's the ultimate market language. This divergence is your friend, not your foe - it allows you to distinguish the Smart Money action from the Crowd actions and position yourself on the right side. This is major difference between the way traders think and the rest of population think.

2. Handling extreme volaitity.

If you are a short-term trader, imagine being an investor at the times when major indices swing as wide as they do these days. 400 points range is almost a new norm for Dow. NASDAQ rallying 40 points in a matter of minutes after talking head on CNBC mentions a rumor? Gut-wrenching... How do you control your risk under such circumstances, challenging even for a day trader?

- keep your position size reasonably smaller than usual
- shorten your holding period to limit your exposure and minimize your chance to get caught into sudden move; book your profits. These are the times when investors go to swing trading; swing taders go to day trading; day traders go to scalping; scalpers.... umm, scalpers remain scalpers, some of them haven't even noticed that there are some major changes underway. Lucky bunch eh?
- never ever let these wide ranges lure you into false sense of security of "it will be back to my price on the next pendulum swing anyway" kind. Market can stay insane much longer than you can stay solvent - keep your stops religiously.

3. Use this market as a tremendous learning opportunity even when you stay in cash.

This is a lifetime opportunity to learn. A lot of things that are usually muted and barely visible are very "in your face" right now.

Watch how major players react and interact - financial stocks, techs, metal-related. Watch how market reacts on news and rumors. Watch how breakouts work, how breakdowns work, how ranges hold. Watch market reactions on news and rumors. Watch which moves get follow-through and which get faded; try to get a feel for the difference so you would be able to tell in the future one from another. Watch when the market becomes totally unpredictable and erratic so that in the future you could recognize such situation as early as possible and go to cash.

Finally, one more thing to observe... it takes us back to our title:

4. History teaches us that it teaches us nothing.

Watch eternal cycle of hope based on denial and fear stemming from lack of understanding of market inner workings. Every piece of "good news" spat out by propaganda machine sparkles explosion of optimism - no matter how lame "news" is. Someone comes to TV and says something, with agenda or just striving for attention - and their words become a gospel or anathema, depending on listener's positioning in the market. Positions are being held despite market going against the holder. Positions are being taken and dumped out of pure emotions; rules are being abandoned. Emotions run high making people do a lot of stupid things. Observe it all as, just as in previous point, when the heat is that high all these things are seen very clearly . Such heightened tension as we have now serves as a photo film development.

It may sound a bit cynic at the time when the wealth is being destroyed at such rate, but let's say it again... as a trader consider yourself lucky to have such learning opportunity. Use it to its full extent.

Oh, and by the way... The quote that served as a title for this post is a cute simplified form. Full quote from Hegel is even more telling. “What experience and history teaches us is that people and governments have never learned anything from history, or acted on principles deduced from it”.


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