Profit From Prices

A book on stock market trading
By Jayesh Patel, CFA

......Chapter 1 continues

Chapter 1

Trading: Some thoughts

 

Trade for Big Profit and Small Losses

If a trading position generates profit/fun, an individual usually tends to avoid any risk to the unrealized profit. So at the first sign of any risk, a profitable position gets closed. The result is: a successful trade is often closed too soon. The result is small profit and short-lived fun. On the other hand, if the position is generating loss/pain, he will tend to wait for some miracle that can bring the price/fun back so he can profit or break even! The result is: A wrong decision turns into a marriage. He ends up waiting too long mostly letting losses get bigger and consequently shattering his peace of mind. In short, most of the time, profits are short and losses are big. How on earth with an average of around a 50% success rate in trades can one make money in trading with small profits and large losses? Traders should be doing the contrary –Going short on pain and long on fun, having small losses and big profits: turning a correct relationship into a marriage but trying to sever any bad selection as soon as possible.

   

Be Rational when you trade

Individuals are rational but not at all times. There are times when they act irrationally. In a profitable position, an individual tends to avoid risk; while in loss, without knowing it, he is likely to embrace risk. Let us take an example.

Given two alternatives (1) a 50% chance of a 1000-dollar profit and a 50% chance of nothing, versus (2) a sure 500-dollars, most people would take the second alternative. Why? They don’t want to face the uncertainty (take the risk). Most individuals would find 500 dollars in their pockets much sweeter than pursuing the uncertain 1000 dollars.

Now let us think about an opposite situation with two alternatives (1) a 50% chance of a 1000-dollar loss with a 50% chance of no loss versus (2) a sure loss of 500 dollars.   What do you think most investors would do? They would take the first bet.  They would take the risk to avoid the sure loss. Instead of losing 500 for sure, why not take a chance to lose nothing! Similarly in trading, when a person is in profit, he is most likely to avoid risk but when that same person is in loss he is most likely going to take a risk! The Efficient Portfolio Hypothesis assumes that investors are rational; but I have a different opinion - there are times people are not rational. There are times when individuals can’t control their emotions and in stock trading, emotions are more likely to act against them than to help them. Instead of big gains, most individuals are more likely to end up with big losses and small gains.

The Market is Forward-Looking

Most common investors are often at a loss with the market. They often don’t understand what is going on in the market. When the market is staging a smart recovery in the middle of most, if not all, bad news, most people don’t believe in the possibility that the market has entered into an up-trend! This is normal because after seeing a decline for a considerable amount of time, most individuals tend to doubt any recovery in prices. So first they keep watching the rising prices from the sidelines believing that the rally will soon fade and that the prices will start going down again. However the prices keep going up. Then when the prices have gone up quite well, people will start hearing upbeat comments from analysts, reporters and/or their friends. So at this higher level of prices, they somehow get convinced that the market is really going up for good. My point is- most investors anticipate prices to keep going down when the market is at already nadir and when prices are very high, somehow most investors feel very comfortable with the market.  I think this is the reason why most investors are not able to make money in stocks- they play stocks by hindsight rather than by foresight. They fail to understand that markets are forward-looking.

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