Innovative Trading - Day Trading
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Innovative Trading - Day Trading

The Power of Contrary Thinking

Following the trend is an accepted way of making money from trading. Trends persist and if we can lock into and hold them they can yield us great long-term profits. There is however, a lot of money to be made by spotting trend changes. It is at these turning points where we can trade with the best risk / rewards. Spotting them is easy when you know what to look for.

The key to spotting these trend changes is the reaction of traders themselves. Contrary Trading is based upon a constantly recurring phenomenon, which has remained constant for thousands of years - Human Nature. All you need to do is to study the response of traders to price action. You can then be trading in the opposite direction to the uninformed herd and know that you have a high probability of being right. You now have the opportunity of joining the minority of informed traders who make substantial profits from trend changes.

HOW INVESTORS DETERMINE PRICE

“There are in the fields of economics no consistent relations and consequently no measurement is possible.” --Ludwig Elder Van Mises

Many investors believe that price is determined by a simple tug of war between supply and demand factors. They feel that the fundamental study of this area is all that is needed. For example, in financial markets the fundamentalist will look at corporate earnings, interest rates, changes in money supply, and many others. In agricultural markets such factors as planted acreage, crop reports, weather considerations and transport would be important.

However, as B. Pugh states:

“All the crop news and political events will be of little use. If it were possible to trade successfully by good and bad weather conditions, it would be unbelievably easy to make money when the news filters through ten or twenty thousand minds interested in wheat. The major opinion may be quite different from the opinion of an individual.”

Let’s define exactly what a futures market is. It is in effect an area to bring buyers and sellers together and facilitate trade. A futures market does not exist to ration supply and demand, nor to allocate resources, but simply to facilitate trade. It is a perfect example of the free enterprise system at work.

“By nature men are nearly alike, by practice they get wide apart.” --Confucius - The Confucius Analects

It is the market participants that ultimately determine the price of a commodity. There is no scientific theory or formula that determines what the price of anything should be. The facts and statistics are there for all to see. However, people’s opinions on the statistics vary. All of us make personal, subjective, emotional judgements, along with all the participants that ultimately determine price. Our decisions are affected by our emotions. We can all be logical and rational, and it is this side of our nature that has allowed us to advance in such areas as medicine, communications and computer technology. However, we are fundamentally emotional beings; this is an innate part of our nature, and we are subject to a variety of moods including hope, despair, euphoria, greed, fear, optimism, pessimism and many more.

If you want a graphic example of how humans determine price, think of what happens when you exchange a worthless piece of paper for a variety of goods. Money relies on a shared consensus for its value, which would disappear if the consensus evaporated.

“Men at some time are masters of their fates, the fault dear Brutus is not in our stars but in ourselves, that we are the underlings”. --William Shakespeare - Julius Caesar

There is one statistic that has remained constant in investment since records were kept - and that is the ratio of winners to losers has remained constant over time. On reflection this would seem a startling fact, but despite the massive advance in economic forecasting methods and supply of information, the ratio remains the same. Being in touch with all the market news will not, as B. Pugh pointed out, put your investments in the plus column. The obvious conclusion to be drawn is that success in the market is dependent on something else. That something else is emotionalism and how it affects our personality when we invest. It is our emotional make up that is the weak link in the investment process.

“We cannot escape it (emotion). In the future it will cause another panic in Stocks. When it comes, both traders and investors will sell Stocks, as usual, after it is too late, or in the latter stages of a bear market.” --W.D. Gann (1949)

It is emotion that causes the majority of investors to be wrong at critically important turning points - to quote Gann again:

“Therefore, in order to make a success, the trader must act in a way to overcome the weak points that have caused the ruin of others.”

PANIC, MANIA & HUMAN NATURE

“Never underestimate the power of human stupidity”. --R.A. Heinlein

There are many who believe that yesterday’s markets were different to those of today. The facts, however, illustrate that markets today are just as influenced today by human emotion as they ever were. I want to now illustrate the effect of emotion on traders with specific examples, and then analyse the lessons that we can learn. By seeing how the vast majority lose, we can hopefully step aside from the crowd and enter the elite minority who profit consistently from the markets.

In looking at the effect of emotions on the investing public, and excellent place to start is with Charles Mackay’s delightful book “Extraordinary Popular Delusions and Madness of Crowds” published in 1841. MacKay covers three manias we all remember from school, The Tulip Mania, The Mississippi Madness and The South Sea Bubble.

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