Friday, May 30, 2008

The 7 Psychological Pillars to Successful Trading

Psychology of the Call (POTC) believes a majority of a stock's price volatility in the short run (1 day - 3 months) is tied to investor sentiment/psychology. The remaining components are split between the underlying stock specific fundamentals (metrics/ratios), future cash flows, and the S&P 500 Index(S&P). Therefore anyone who trades without weighing investor sentiment/psychology first, perhaps placing a greater emphasis on accounting metrics, will eventually lose money as volatility washes them out. Even though the stock market is a forward-looking discounting mechanism in the longer term (6 months or more), in the short term a stock's price is more like a washing machine, churning and churning, not always showing the true threads of cotton or silk. We don't try to outthink and outsmart the short term volatility tied to sentiment/psychology. It’s better to use short term trends to your advantage, especially if the rest of the puzzle is convincing, i.e. rising future cash flows, superior technology patents, sound management. Perhaps First Solar's (FSLR) recent pull back from over $300 to $250 is the best example, as the psychology of crude oil and government legislation has recently gone against a still very promising company. Now for the Pillars we believe in:

1) We believe in patience. A patient trader waits for superior opportunities to enter and exit. A trader who forces trades after winning or losing will set him/herself up for potential losses, because gambling, rather than psychology has taken over the mind.

2) We believe a stock's volatility is a positive attribute. Volatility can be caused by stock specific news related to earnings, management changes, law suits, technology/patents, market share, or short interest. Volatility can also be caused by the overall market/S&P. We take advantage of price volatility, setting specific entry and exit points based on basic technical analysis, with emphasis on the 200 day moving average.

3) We believe in only trading above average entry points, as the over sold and over bought stocks become evident to our trained psychological eyes. Learn to take advantage of these superior entry points, as wash outs and peaks offer attractive premiums as you go against the herd.

4) We believe the market will be around next Friday, next month, and next year, so we take one day a week off in order to clear our minds. Cultivate a hobby because a healthy life style contributes to a healthier mind. Better trading decisions result when we are well rested and involved in other things besides trading. Go fishing, visit a Museum, tend to your garden, tinker with your car, forget about stocks for a day.

5) We believe investor sentiment/psychology and S&P swings affect individual stock movements in the short run more than any fundamental metric or ratio. Exhibit caution when attempting to trade on backward looking fundamental analysis, forward P/Es or future cash flows.

6) We believe there is only one Warren Buffet, but if you master market mechanics you will be become a multimillionaire by understanding, appreciating and trading volatility.

7) Finally, we believe the importance of maintaining some cash/liquidity in the portfolio and always booking profits, but especially on Friday, as smart money sells to avoid the risk of some weekend geo-political event.

The Psychology of the Call team now offers you the 11 Commandments:

The Eleven Commandments of Trading

1. Never trade more than 10% of your total capital/account value in any one position.

2. Cash is King, and we recommend keeping 20% liquid to take advantage of dislocations and volatility.

3. Cut losses to 15% maximum whenever possible. If your psyche is shaken, step away and don't trade for 1 week.

4. Take and enjoy profits of 30% or more.

5. Never fall in love with a stock and never force trades or over trade; remember commandment #2.

6. Never accept excuses from management, period.

7. Use technical and fundamental data & psychology/sentiment from the conference call to select trades.

8. There are two sides to the market, long & short; take advantage of that leverage.

9. Understand the significance of the macro geo-political economic environment.

10. Unforeseen events/shocks will happen, inverting the market upside down (remember commandments #1 & #2)

11. All of the above are void without reading the Psychology of the Call.

1 comment:

Anonymous said...

You make some very good points.