Thursday, March 04, 2010

Confusing individual play outcomes with sound strategies?

I just noted the tendency for the human mind to block out failures and see only the sunny side up in trading, and perhaps life. Human nature and sustained, consistent trading success do not typically go together well.

Today, in the Tim Alerts Chat room where I hang out each day lately making calls and observations about (usually) penny stock trades, an alert was issued by the moderator on TIVO, which was reacting in real time to intraday news explosively. To his credit he reminded the peanut gallery that his observation of stocks having momentum acceleration was NOT in and of itself a reason to base a trading decision on blindly. Trading alerts without understanding why or knowing the risks is like russian roulette.

In trading you look at SEVERAL things in combination usually before pulling the trigger. All successful traders with consistent returns will ask about the risk reward of a play, the entry and exit plan if things go well or poorly, and a host of other odds related specifics to determine their actions regarding a stock.

The stock went vertical immediately. The alert, which in hindsight seemed early, already had a big move up. Many traders watching wanted to go long. If they had, they would have had a huge day acting on this call.

A similar situation occurred in ZANE.

Irrational exuberance tends to reign supreme in such situations, unfortunately. Most of the people who wanted to go long in what statistically should/would be too late to allow good risk to reward felt regret that they could not pull the trigger, failing to see that they had the benefit of hindsight and had at the time of the decision the hard right edge of the chart to contend with. They applauded those that banked coin, without criticism, because after all, who can argue with such seeming success? Is this negative reinforcement? I think so!

In short, they confused an individual outcome of a play with statistically reliable sound strategies and approaches in day tradings, a common fallacy. In reality, situations like ZANE and TIVO are mighty exceptions, not the rule. When one arrives after several vertical big green candles and tries to go long, becoming a bag holder is much more likely than becoming rich.

But when people see an insane move, they want to be in at all costs, to have a piece of the action! They never ask themselves how *often* such late entries end in disaster as opposed to banking fat coin. The lure of a huge score is simply too much for logic to get in the way. Entering late is usually a losing proposition over the long haul, and you have no way of knowing that THIS play will be the one that moves another 75% above its already up massive price level. Not getting good entries for fear of missing out leads to bad returns over time.

Friends, the stock market is a brutal cut-throat place. Trading is a hard game that takes a lot of work. See this post by another excellent blogger:

If it were a sure thing to succeed like this, we could all quit our jobs after subscribing to Trade the News and retire without having to learn anything more about trading. Who needs to learn anything else if all you have to do is get the news a little faster than the next guy on a big % mover?

These pure momentum (often scalping with size) plays ARE sometimes plausible longs IF you are quite early, which can take a bit of luck. Usually when momentum seems to fade you have to get out without being greedy and not try to hold for hours. I have been lucky like that with a few stocks. But assuming that a stock already up insanely will keep going up to make an even bigger score is a dangerous mind game to entertain. 

The risk/reward simply is typically not there to permit a sound play long based on the facts known at the time. You cannot assume TIVO and ZANE are typical, they are incredibly exceptional. As I said in my other post tonight, people tend to only see the individual outcome that they want to see, often with the benefit of hindsight, not the hard math that must dictate trading decisions based on facts known at the time of decision, taking into account the probabilities of success in a detached manner to base a play on.

Do not join the ship of fools lightly unless you want to get wet!

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