Trade What is Real, Not What You Feel

Remove the Veil of Illusion from Trading and Investing

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 attain. The objective and mechanical rules for consistent low risk profits are very simple, yet the layers of illusions 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 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 subjective, complex illusions on top of each other. This is a recipe for consistent failure.

What many beginning traders don’t realize is that they are stepping onto an airplane, flying from Chicago to California, trying to reach London. 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 of price movement: 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 and 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 lie. It’s time to start considering where your beliefs come from about 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.

Figure 1

Moving Averages

The Illusion:

The chart above is a daily chart of the S&P 500. 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 (MA) 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 MA’s actually offer a benefit when used in these conventional ways is completely false. It is an illusion.

In this chart, a 20-period and 200-period moving average are seen. These are widely used moving averages both in the trading and investing community. 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 a MA as a trend filter 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

MA’s 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" that 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 trader/investor 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.

The Reality:

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 are 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 becomes "out of balance." In other words, there were many more willing and able buyers at "A" than there were sellers. 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 are more willing buyers than sellers. "B" is the low risk/high reward opportunity to buy. Buying in these two areas ensures three important musts in trading and investing. First, your protective stop must be as small as it can be, which offers a trader proper risk management/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 are out-of-balance.

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.

Figure 2

The News

The Illusion:

The news illusion is the most powerful illusion in trading and investing as 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 thought of a major terrorist attack in London led many to believe that prices would fall; that belief drove the majority to sell. Once the last seller sells at a price level where there are more willing buyers than sellers, the laws of supply and demand tell us prices rise.

Lesson: No matter how bad the news is, when the last seller sells at a price level where there are more willing buyers, prices rise. There can be no other mathematical outcome.

The Reality:

Area "A" on Figure 2 is an objective demand price level as the origin of the supply/demand imbalance is at the point in which prices move higher from area "A." Area "B" represents the day of the London bombings. The news of the London bombings was very real, very bad, and prices fell. However, once they reached area "A" where there was objectively more demand than supply, prices turned higher.

The Lesson: 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.

Figure 3

Fundamental Analysis

The Illusion:

In some cases such as the chart above, there are a number of illusions at work at once, severely clouding reality. This example shows CTXS, a Nasdaq stock. The rally in price in CTXS, as the stock revisits the area of supply (imbalance), is accompanied by good news on a brokerage upgrade. A gap up in price is seen, which is accompanied by the brokerage upgrade (source: Yahoo Finance). 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 stock and why, all we need to know is this: Are prices at a level where objectively, there is more demand than supply? If the answer is no, there is no reason to buy.

Not only is the answer no at the time of the brokerage upgrade in CTXS, but the laws of supply and demand tell us we should be selling here, not buying. This upgrade, which invites the novice market speculator to buy, is given right into an objective supply area where we know there are more willing sellers than buyers. The eventual drop in price from this level is fast and strong for one simple reason. The number of willing buyers at this price level became zero while the number of willing sellers was still significant (supply/demand imbalance).

All this information was available to us prior to the rally in price (the gap). But most market participants didn’t see it, as the illusion was too strong. Adding to the illusion was the gap up in price, the bigger the gap, the more herd mentality people desired to buy into it. We are humans: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 Reality:

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. Objectively, the worst possible action to take is to buy anywhere near this supply area, especially on the first rally into it. Many illusions, however, invite the masses to buy at the absolute worst time and there is a reason for this…

The Lesson: When perceived risk is lowest, actual risk is often highest. When perceived risk is highest, actual risk is often lowest.

Illusion: Everything in the company is good; therefore, the stock is a quality investment.

Most people require specific criteria in order to feel comfortable buying a stock. These criteria likely include:

Figure 4

Buying High?

When all of the illusions in the box are true, where do you think the price of the stock is? If you said "high," you are correct most of the time. If you buy when everyone else is taught to buy and when the stock 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, which includes 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 "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 as they consistently buy after the reality-based trader buys. In short, the reality-based trader typically derives his or her profit from the actions of the mass illusion-based crowd.

Act Like A Goose

The human mind is not wired to trade properly. Our decision-making process is not like most other animals. Most people don’t focus on reality when deciding to take action; we make decisions based on emotion, not intellect. Not only is it very difficult to live in complete reality, but consistent action based on reality is an even harder task many times. A goose, on the other hand, would make an excellent trader and investor. When autumn approaches in the north, the geese don’t wonder if winter will come or not. They certainly don’t call a goose meeting to figure out a way to stave off winter. They simply act like a machine and fly south for the winter and repeat this process each and every year, flawlessly for their entire life, without questioning their choice.

Throughout history, people that pioneered original reality-based thought on certain topics often paid for it with their lives. An example that comes to mind was the crazy thought that the world was round. Though your life is certainly not in jeopardy with illusion-based trading and investing, the growth of your hard-earned capital sure is.

The Three Laws of Price Movement

I have been involved with trading and investing for more than ten years, and the consistent low risk profits I have produced are a function of trading what is real, not what I feel. I eliminate subjective emotions by basing each and every decision on a simple mechanical set of objective rules that quantify supply and demand. These simple rules, which are beyond the scope of this article, stem from three laws of price movement I crafted long ago. These three laws form the foundation upon which the whole system of proper trading and investing lie.

Laws of Price Movement:

Price movement, in any free market, is a function of an ongoing supply and demand relationship within that market.

Any and all influences on price are reflected in price.

The origin of motion/change in price is an equation where one of two competing forces (buyers and sellers) becomes zero at a specific price.

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 straight-forward 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 sound trading and investment opportunities is not that difficult a task.

Have a great day.

Hope this was helpful, have a great day.

As the Vice President of Education at Online Trading Academy, Sam brings over 15 years experience of equities, forex, options and futures trading which began when he was on the floor of the Chicago Mercantile Exchange where he facilitated institutional orderflow. He has traded equities, futures, interest rate markets, forex, options, and commodities for his personal interests for years and has educated thousands of traders and investors through seminars and daily advisory services both domestically and internationally. Sam has been involved in the markets since 1991 both on and off the floor of the Chicago Mercantile Exchange. He has served as the Director of Technical Research for two trading firms and regularly contributes articles to industry publications. Sam is known for his trading, technical research, and educational guidance.