Trading Lesson of the Week

Check back weekly for another free trading lesson:

Never Fall In Love, Is the Stock Market Crash Over?

In This Week’s Issue:

  • Stockscores’ Market Minutes Video – Is the Crash Over? How Support Works
  • Stockscores Trader Training – Never Fall in Love
  • Stock Features of the Week – Abnormal Breaks

 

Stockscores Market Minutes – Is the Crash Over? How Support Works

After a rough week for the market, many are asking if the stock market crash is over. This week, I explain how trend line support works and how it is working for this market. Plus, the trade of the week on VXX.

Click here to watch on YouTube

To get instant updates when I upload a new video, subscribe to the  Stockscores YouTube Channel

 

Trader Training – Never Fall In Love

Happy Valentines Day. Chapter 10 from my book, "The Mindless Investor" seemed appropriate this week. More information on my book can be found at www.stockscores.com/mindless.

I have made thousands of trades in my life, and the ones that stand out as the worst-those that not only lost me a lot of money but also took a great deal of emotional capital-are the trades where I knew too much. I understood the company well, I listened to and believed in the story, and ultimately, I fell in love. In trading, love is cruel. By doing the in-depth fundamental analysis of the business, I established an emotional relationship with my stocks and overlooked their failings. When the trades went bad, I stuck with them and allowed big losses to happen.

I have suffered big losses as a result of love affairs with individual stocks more than once. We are supposed to learn from our mistakes, but that process can be slow, and along the way financial losses can mount. I want to help you avoid the pain that comes from love-at least, misdirected love for a company story.

Knowledge Can Be Dangerous
Suppose you are given a set of strategy rules by an expert trader who has found that the strategy makes $500 a trade when it is right and loses $200 a trade when it is wrong. The trader assures you that the strategy has been profitable 70% of the time.

You start trading the strategy, and, after making 100 trades, you find that the expert trader was right; it was profitable 70 times, making you an average profit of $500 each time and losing you an average of $200 thirty times. Over the 100 trades, you made $29,000 (70 × $500 − 30 × $200).

As you move into your next 100 trades, you find a stock that meets all the criteria of the strategy that the expert trader gave you. You move in and buy the stock, following the rules of the strategy. Later that day, you are discussing the trade with your neighbour, who tells you that she actually works for that company and that you have made a great trade because the company has big results coming. It turns out that the company is in the mining business and is exploring for gold in the Nevada desert. It has had excellent preliminary results, and she thinks it is going to be a sure thing. She tells you how everyone in her office is buying the shares because they know how great an opportunity it is.

You know the market agrees with her because your new system gave you an entry signal. You read up on the company a little more and find out that the company management has a great track record for finding viable gold mines; they have done it three times before. You also discover a website that has an analysis of the preliminary results by an independent geologist who does not work for the company, and he has put a strong buy rating on the stock with a $10 target. You already bought today at $5.

Although the rules of your expert's system limit position sizes, you decide to buy more. Breaking the rule at this point seems reasonable given the information you have, especially since people that work at the company are buying too.

You are surprised when, three days later, the stock price falls and hits the stop loss point defined by your system. This is the point where you were supposed to take a $200 loss, but because you bought a lot more of the stock you are faced with a $1000 loss. You decide to stick with the trade after your tipster neighbour tells you to expect results the following day. It feels good to have some inside information.

Results do come out the following day, but they are not what you expected. The company did not find gold, and the venture is a bust. The stock drops to $2 a share. Your loss has now ballooned to $15,000.

This single loss represents the profits of 30 winning trades in your system. What should have been a $200 loss grew to 75 times that, all because you broke the rules of your proven strategy. Your neighbour feels bad for giving you the tip, but she has her own problems: she had invested every penny of her savings into the stock and is now faced with a huge loss too.

Are You Normal?
Does this situation sound familiar? I have heard this kind of story too many times for it to not be common. We, as emotional human beings, easily fall into this trap, not because we are bad or stupid people but simply because we are normal. Normal people are predisposed to fail in the stock market.

When you know too much you ignore the message of the market. You avoid information that works against your thesis for a trade. You see what you want to see.

There is actually a good biological reason for this. Optimism is inherent in people; it gives them the will to overcome great obstacles to ensure survival. Imagine being a settler of a new land and facing a severe storm that threatens your existence. If you focused too much on the reality or your dire situation and had no optimism, you would probably not find the will to overcome the adversity. Optimism is what gives you the strength to survive.

It is easy to carry this survival instinct to the stock market. If you have a substantial amount of your net worth wrapped up in a stock, it is likely that you will do whatever you can to make yourself feel comfortable with it. You will read news releases with a focus on the positives. If you encounter some negative comments about your company, you will find a reason to discredit the source. If some bad news comes out, you will search for some expert, no matter how obscure, to tell you that the bad news is not important and that the long term potential for the stock remains.

This is a love that grows out of our emotional attachment to money. Just as a mother loves her children unconditionally, so does the investor who has developed an emotional relationship with a stock.

Investors who study public information are really just looking for a reason to feel good about the stocks they own. There is no value in knowing something the market already knows because the information has been priced in to the stock. The danger is that this information could lead to an emotional attachment to the company that ultimately impairs your judgment. If impaired judgment is a risk and public information has no value, why consider it? 

Avoiding a Personal Bias
When I am considering a stock, I try to make one argument for why I should buy it and another for why I should short sell it. These are two opposite trades with opposite expectations for future direction, and doing this encourages me to take out my personal bias and look at the facts rationally to determine the best trade to make. I don't really care whether I buy or short. I know that I can make money both ways, so I only want to do what my analysis tells me has the best chance of success.

I am not looking at fundamentals when I make a trade; I instead use the methods I will teach you later in this book. Whether you use my method or not, it's important to avoid information bias.

Missing the Point
When you fall in love with a stock, you tend to focus on the elements of the company story that fit with your optimistic outlook. Misguided focus can lead to bad results even if you interpret the facts correctly. The market tends to focus on only two or three key things, and those factors are what drive price performance. If you focus on the wrong information your analysis can lead you to a bad trade.

For example, someone doing fundamental analysis of a construction company will likely focus on things like the number of houses the company is building, the margin, how strong the company's balance sheet is and the quality of the company's management. This analysis could indicate that the company is very strong and the stock is worth buying.

What if that's not what the market is focused on? If the market is focused on an expectation that interest rates are going up, which would hurt the housing market, then this stock will not do well, despite the otherwise positive situation for the company.

This is a mistake that happens to investors all the time. They buy a stock for all the right reasons and still suffer a loss because they failed to see the one negative thing that the market ultimately cared about most. There are many factors that can affect how a stock's price moves; failing to account for all of the important ones can make good analysis fail.

Wanting a Return on Your Investment
Good and thorough fundamental analysis takes a lot of time, and that investment of effort creates another bias that can cause us to hang on to a loser. If you spend 20 hours analyzing a company before you invest in it, what are the chances that you'll admit your analysis is wrong?

Some people are capable of scrapping a trading idea no matter how much work went into it, but for most, it's hard to throw away that effort. We'd rather hang on, hoping the market will eventually prove our hard work was worth it, instead of throwing in the towel when the market has shown us to be wrong.

This investment of time gives us one more reason to see what we want to see. It provides a basis for optimism when the market is giving us adversity.

Never Fall in Love
There is a danger in knowing too much. We develop a significant bias when we put a lot of time into gathering information. We become loyal to a stock when we understand and believe in the company's fundamentals. It's easy for us to ignore conflicting information when we are emotionally attached to a stock.

These things can cynically be described as "falling in love," and they often end in pain. As long as you are a normal person, you are likely to succumb to emotion in some way. The market is going to prove us wrong some of the time, and we need to be capable of seeing that proof when it's in front of us. I will show you my method for knowing when you're wrong later, but for now, understand that you must avoid knowing so much about a company that you lose touch with reality.

 

Get the weekly email from Stockscores founder Tyler Bollhorn

Get our weekly trading lesson and stock trading ideas direct to your email in box with the Stockscores Foundation newsletter.

Learn how to be a better investor and trader plus see how to best utilize the tools of Stockscores.com.

This is a free service from Stockscores with no spam (we hate spam!). Enter your email address below to register for future email editions and see the archive of past newsletters.