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Perception Versus Reality – Trade What Is Real, Not What You Feel (Part 3)
Education | 13 April 2012
By:

By Sam Seiden (Online Trading Academy)

The two main forms of analysis in trading and investing are technical and fundamental analysis, and they are very real. However, thinking that mastering these two forms of analysis will lead to consistent low risk profits is an illusion second to none. The more an individual attempts to master these types of analysis, the more they may be layering subjective complex illusions on top of each other. This is a recipe for consistent failure. This article will focus on unveiling the major illusion of Fundamental Analysis.

The Illusion:

In some cases, such as the chart of Intel Corporation (INTC) below, there are a number of illusions at work at once, severely clouding reality. INTC is a technology stock that most people are familiar with. The rally in price in INTC, as the stock revisits the area of imbalance, is accompanied by great news on earnings. A strong “uptrend” in price is seen as well. The illusions here are many and create strong beliefs that lead to everyone buying in this case. These beliefs lead to action (buy or sell) and this action (buying and selling) is all we need to be concerned with. No matter who or what is telling us to buy the stock and why, all we need to know is this: Are prices at a level where there is objectively more demand than supply? If the answer is no, there is no reason to buy.

“Last night, Intel said quarterly earnings quadrupled to 43 US cents per share, topping the consensus view of 38 US cents per share. Revenue rose 44 percent to trump forecasts as technology spending has increased among consumers and corporations.” – AP

Intel Corporation reaches profit targets

Again, many illusions come into play in this example. The illusion-based trader saw a high risk/low reward buying opportunity at the supply level, while at the same time, the reality-based trader, we at Online Trading Academy saw that same opportunity as a low risk/high reward shorting (selling) opportunity.

The Reality:

The objective supply (resistance) area is labeled as such, because it is a price level where supply and demand is out-of-balance. Put simply, there is too much supply. Again, prices can only drop from that area because there are more willing and able supply than demand, there can be no other reason for the decline in price on the left. Objectively, the worst possible action to take is to buy anywhere near this supply area, especially on the first rally into it, which is when we instructed students to sell short. Many illusions, however, invite the masses to buy at the absolute worst time.

The Lesson
When perceived risk is lowest, actual risk is often highest. When perceived risk is highest, actual risk is often lowest.

Illusion:
Everything in the company is good; therefore, the stock is a quality investment. Most people require specific criteria in order to feel comfortable buying a stock. These criteria likely include:

  • Good earnings;
  • Strong balance sheet;
  • Solid management;
  • Stock price moving higher;
  • Brokerage upgrade;
  • Strong economy.

Buying High?

When all of the criteria here are true, where do you think the price of the stock is? If you said “high”, you are correct most of the time. If you buy when everyone else is taught to buy and when the stock price is high, who is going to buy from you? Remember, the only way you can derive a profit from an investment or trade is when someone buys from you at a higher price than what you paid. This is no different than buying and selling anything, which includes real estate, automobiles, computer, groceries, and much more. Would you ever offer to pay a higher price than the car dealer was asking? Of course not. Yet when your favorite car is on sale for half price, I bet you will buy it as fast as you can. This is the exact opposite action that most people take in the markets when putting their hard-earned money at risk.

The many illusions are nothing more than risk disguised as opportunity. Falling prey to a variety of market illusions makes it possible to disguise irrational behavior as “safe”, “proper”, or “accepted”. An illusion is an erroneous perception of reality. Illusions lead the average trader and investor to commit two consistent mistakes:

  • Buying after a period of rising prices;
  • Buying at a price level where objectively willing supply exceeds willing demand.

Both of these actions are completely inversely related to how you profit when buying and selling anything. They go completely against the laws of supply and demand. However, we do not want illusion-based traders and investors to go away. Why? We need them on the other side of our trades. In short, the reality-based trader typically derives his or her profit from the actions of the mass illusion-based crowd of novice traders and investors.


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The Shares Investment editorial team welcomes constructive feedback on our coverage and content. We would also be delighted to answer any questions on the above article. Leave us a comment below, and we'll get back to you shortly!

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