The Behavioral Science of Trading
In This Week’s Issue:
- Upcoming Events – Webinars in the next month
- New Video – How I Set Up My Trading Computer
- Stockscores’ Market Minutes Video – Stock Market Corrections – How They Can Be Profitable
- Stockscores Trader Training – The Behavioral Science of Trading
- Stock Features of the Week – Abnormal Breaks
Upcoming Events – Free webinars this month
Free webinars coming soon, go to the Upcoming Events page on Stockscores to register:
New Video – How I Set Up My Trading Computers
Take a tour of my day trading set up as I show what I use for trading computers plus the how and why I have set them up that way.
Click here to watch the video
Stockscores Market Minutes – Stock Market Correction - How They Can Be Profitable
This past week had a big correction which left many feeling shell shocked. There are ways to make money from corrections and if you do it right, corrections are much more lucrative than normal markets. This week, I discuss that plus my regular weekly market analysis and the trade of the week on VXX.
Click here to watch the video
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Stockscores Trader Training – The Behavioral Science of Trading
While we hear about how markets are traded by computers more and more, I believe that it is still people that move markets. The computers take little bit of profit along the way and may affect the short-term liquidity for stocks, but trends and substantial price moves are driven by human judgment.
This makes it important to understand how humans make those judgments. Traditional stock analysis assumes that we make rational decisions based on the information we have about the company. However, what one person considers to be a rational decision might be considered completely foolish by another. Many investors will make moves that are predictably irrational.
Behavioral economics and finance are fields which have still not hit the mainstream, but many of the theories of these disciplines are part of my approach to the market. Here are some areas of research by behavioral theorists that I find are applicable to what we do as trader and how they relate to some of my trading concepts:
Up trends start slowly, there are often pull backs early in the trend.
"A conservatism bias means that investors are too slow (too conservative) in updating their beliefs in response to recent evidence. This means that they might initially underreact to news about a firm, so that prices will fully reflect new information only gradually. Such a bias would give rise to momentum in stock market returns." Bodie, Kane and Marcus (2005)
People tend to make judgements by what has happened recently rather than what happens most of the time.
"Gambler's fallacy stems from two sorts of confusion. First, people have very poor intuition about the behavior of random events. With gambler's fallacy, they expect reversals to occur more frequently than actually happens. The second source of confusion stems from the reliance on representativeness." Shefrin (2000)
For most people, profits in the stock market are short term loans.
"People are overconfident. Psychologists have determined that overconfidence causes people to overestimate their knowledge, underestimate risks, and exaggerate their ability to control events. Does overconfidence occur in investment decision making? Security selection is a difficult task. It is precisely this type of task at which people exhibit the greatest overconfidence."
How we judge information is largely dependent on our mood.
"The discovery that the weather in New York City has a long history of significant correlation with major stock indexes supports the view that investor psychology influences asset prices."
People often wait to buy a stock until it has been going up for a while, in the end, paying too much.
"People prefer the familiar to the unfamiliar"
You are not smarter than the stock market.
"The illusion of control is the tendency for human beings to believe they can control or at least influence outcomes which they clearly cannot."
For every trade, there is a buyer and a seller. The buyer thinks the stock is going up, the seller thinks the stock is going down. One of them is wrong.
"Psychologists Hillel Einhorn and Robin Hogarth (1978) have studied the general issue of why people persist in beliefs that are invalid, that is, why they succumb to the illusion of validity. Einhorn and Hogarth suggest that people do so because they are prone to search for confirming evidence, not disconfirming evidence."