When I became fascinated with financial markets, it wasn’t to become a trader or even to make money. It was primarily to understand why the markets went down so I wouldn’t have to experience the pain of loss. When the market melted down in 2000, I wanted to understand why it occurred and what the warning signs would be of another slide. That way, I could preserve my assets when a slide occurred.
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I have a degree in History and have always been interested in learning from the past. You might be interested to know how Joseph Kennedy, father of President John F. Kennedy and the late Senator Edward Kennedy, made his fortune. Kennedy made money in an era when things that are now illegal weren’t and things that were illegal then, are no longer. Some of his fortune came from bootlegging operations during prohibition. The part that should be interesting to all of you, however, is that he made money in the stock market.
He started by joining a prestigious stock brokerage firm in 1919 and became an expert at taking advantage of what is now labeled as insider trading and market manipulation. He made a fortune trading in this manner and increased it significantly by shorting many stocks in 1929 helping to fuel the stock market crash. It is important to note that this activity wasn’t illegal then. The fortune he amassed in this manner ranked him somewhere between the 9th and 16th richest man in the United States.
He was personal friends with President Franklin D. Roosevelt and was appointed first chairman of the Securities and Exchange Commission (SEC) when the office was created in 1935. Since he understood insider trading and market manipulation, who better to help clean things up?
What I am trying to point out is that some very successful and respected people have made money when the market has moved higher as well as lower. If you can discern which direction the market is going to move, you can get out of the way or even profit when it will move lower. If you know when it is going to move higher, you can make sure that you are fully invested around the beginning of that move. The trick is how can you know when the market will begin a move and in what direction that move will be? Better yet, how can you tell when a significant move is about to get underway?
For myself, I don’t generally concern myself with how long a move might last and just how vigorous the move will be over time. While I can do projections, they are guess work built on a foundation of mathematics. The math only tells you potential areas for a reversal, but not that the reversal will occur.
I would rather make sure I am on the right side of a trade and stay with that trade for however long it will continue. Therefore, my philosophy is such that I need to take a look at the market every day to determine if anything has changed in terms of market sentiment and trading behavior from the prior day. You can look at all sorts of underlying mechanics in the markets as inputs but at the end of the day, it comes down to where you believe price will go in the relatively immediate future. The most important thing you can monitor is actually how price has moved recently in response to underlying sentiment, previous price action, economic reports, company reports, analyst recommendations, and exogenous events.
The most important concepts in trading action, when looking at a price chart are the following:
- Moving Averages are used to determine whether momentum is moving higher or lower. My system regularly monitors the 20-Day Moving Average (DMA), the 50-DMA, the 200-DMA, and the 100-DMA, but I don’t always show it on all charts. Note that the 100-DMA is equivalent to the 20-Week Moving Average (WMA).
- Support/Resistance Levels. It is important to note important areas where battles have been fought between bulls and bears. These levels will often be fought over time and again. For instance, when the bulls cause price to successfully break up through an area of resistance, this becomes an area of support. After the markets have moved higher, if they then retreat back to this point, the bulls will generally defend that level turning the area of prior resistance into support. This concept of support becoming resistance and resistance becoming support is an invaluable tool in gauging the likely course of market action in the future.
- Overbought and oversold conditions are readily apparent to many market participants. Many traders use indicators such as oscillators to determine whether securities are overbought or oversold. It is the action that occurs when price has reached these levels that will determine where the market is likely to go next.
With these ideas in mind, and using other tools, market behavior can be mathematically mapped. This isn’t enough to tell you where markets will go, but it is enough to understand where they have been, where they are now, and important influences on market direction in the near future. You can then take a look at market internals, sentiment, and some other inputs to arrive at a decision about market state and market BIAS.
To actually be able to use past market behavior to determine the probable future market direction, you need to set-up formal models that arise from behavioral finance. In other words, you need to actually use mathematics to assign probabilities from various influences on the behavior of the crowd, know as the market. This means that some of the behavior will be rationale but some of it will be irrational but predictable.
Much has been learned about the behavior of crowds, primarily due to incidents that involved the loss of life or the deprivation of an individual’s rights. The “madness of crowds” explains the action of hooligans causing riots at football (soccer) games. It determines what happens in riot situations, bank runs, an early morning sale at Wal-mart, etc. A lower profile effort has been put into understanding market behavior in a formal sense and it is the results of this effort that provide fruit to determine future market direction.
To aid me in determining where the major indexes are likely to move (higher, lower, or sideways); I determined that I needed to understand the state of the market. While many traders use technical analysis to assist in their trading, they are missing the most important element in their trading. That is, they ignore the current state of the market in their analysis. By that, I mean that they will determine that the market is overbought or oversold but miss whether the market is actually in a trading or trending state. Most traders believe you can’t determine the state of the market, so they don’t use it. It is the single most important element to properly assessing the future direction of the market.
Likewise, the markets will form a BIAS. Like a human bias, these are hard to change. Prejudice is a negative bias, that is, behavior changes in a negative way if the subject of bias is involved. This could be a racial prejudice, such as held by White Supremacists, such as the Ku Klux Klan. It might be a religious prejudice, such as the WASPS (White Anglo Saxon Protestants) versus the Catholics or Jews in New England. A bias could also be a positive, such as hiring someone you relate to. If you are a white male member of a fraternity at an Ivy League school, you might be hired by another white male member of the same fraternity who attended the same school. Even though there was no prior relationship there, the bias is clearly positive.
So it is in the markets. When there is a bullish or bearish bias, the markets will more quickly move back into that direction when they are moving counter to it. This means that any trades entered that are counter to the bias can quickly reverse themselves, and the way that opportunities are traded should take this into account. Therefore, BIAS is an important element in the trading system that I evolved.