When does a stock stop going down?
a) when there are no more sellers left;
b) when it has reached reasonable valuation;
c) when the economic/business conditions causing the decline have reversed.
If you answered b) or c) – you need a primer in trading psychology. Any trader worth his salt will tell you that the correct answer is a) – when there are no more sellers left.
Stocks trade on perception and emotion. The underlying reality serves as a base, a springboard, a starting point. If the market were based solely on reason, it simply wouldn’t exist. Assets would be assigned an “objective” valuation by a recognized committee of learned men based on a universally accepted formula, and re-appraised periodically. It’s the speculators that make the market tick by trying to anticipate the facts and get in ahead of the crowd for a quick profit. If you wait for all the facts to come out before making a commitment, you are invariable too late. Just think about all the times when the good news was finally out and the stock went down, taking you with it.
Trading on anticipation explains why the market is 3-6 months ahead of the economic cycle. Realizing that the earlier one gets in the better, more aggressive speculators try to get in ahead of other speculators.
Since the market trades on emotion, successful speculation also means anticipating how others will react to the news in order to devise your own course of action. Suppose a company in which you own shares announces some really bad news over the weekend. What do you do?
What do you think others will do?
Amateurs probably won’t notice, or being the starry eyed optimists they usually are, will tend to discount, or rationalize away, the bad news, particularly if they have purchased the stock recently and don’t want to face the loss. They will probably be adding to their positions “on the pullback,” arguing that the market got it all wrong.
Bargain hunters will put in their limit orders to get shares at a discount.
Professionals, however, may decide to sell. Those with large positions will have to device elaborate sell programs for Monday to get out with a minimal loss.
If you are a part-time investor, your gut reaction may be to put in a sell order at the market on Sunday night. Now, think about it: if this is what you decide to do, chances are so will many others like you. The result – a backlog of sell orders at the open.
Specialists / market makers whose job is to maintain orderly markets in the stocks assigned to them will have to absorb all that extra supply coming to the market. However, they are under no obligation to buy it from you at your price. They will drop the price sufficiently to realize a quick profit later on in the day, so the stock gaps down at the open. Many limit orders get filled, but to draw in the rest of the value crowd, the stock has to start rising from its intraday low, making people think the worst is over and it’s safe to get back in.
As the stock bounces, bargain hunters step in to scoop up the shares flipped by the specialists / market makers who had bought at the open. If you think it’s time to get back in – think again. The professionals with large positions are still waiting to unload. As the stock bounces back up, their sells kick in, checking the advance. As the stock begins to sag under the weight of their orders, they stop selling, and may even buy some back to support the price and make others think the worst is over.
How do you benefit from all this? Knowing, or at least anticipating, the above will at the very least save you from trouble. But if you want to run with the big dogs, you need to know how the game is played.
Slav Fedorov is a full time stock trader and founder and managing member of TradingZoom, LLC – a provider of proprietary trading data that swing traders can put to work right away. http://www.tradingzoom.com/
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