Perception vs Reality − Trade What is Real, Not What You Feel

by Sam Seiden
http://www.fxstreet.com/education/trading-strategies/lessons-from-the-pros/2010-09-08.html

Consistent low risk profits from trading and investing is a challenge many millions of people take on, yet only a select few are ever able to attain. The objective and mechanical rules for consistent low risk profits are very simple, yet the layers of illusions keep most from ever seeing what is real in trading and investing.
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.
What many beginning traders don't realize is that they are walking east and west trying to reach the North Pole. No matter how hard they work, the goal they desire is not attainable as the path they are on is an illusion. Trading strategies that work don't change with time or changing market conditions. Quite frankly, to think market conditions ever change at all is a strong illusion that can only be removed when one focuses on the foundation of price movement: Supply and demand. A simple and minor shift in perception to what is real can lead to a monumental shift in trading and investing performance.

The focus of this piece is to identify and remove the veil of illusion from trading and investing. How? By realizing that the movement of price in any market is based at its core on an ongoing supply/demand and human behavior relationship and understanding that low risk/high reward opportunity exists when this simple and straight-forward relationship is out-of-balance. First, I will quantify a supply/demand imbalance for objective opportunity. As most traders are well aware, the overall goal is to decrease risk and increase profit potential. But many novice traders' strategies actually accomplish the opposite. Results for everyone from the active trader to the casual investor follow from taking various actions. Instead of focusing on changing our actions, it's time to notice where those actions come from.

Beliefs and Behavior Patterns = Actions

Let's move backward, one step at a time. Actions stem from behavioral patterns, and behavioral patterns stem from beliefs. It is at the level of beliefs that decisions are made, and moreover, where your ability to differentiate reality from illusion lies. It's time to start considering where your beliefs come from about what works and what doesn't. The strongest illusions in the trading and investing world are found at the core of fundamental and technical analysis. Within these two forms of analysis lie many levels of illusion. In this piece, I will focus on three major illusions.

Moving Averages

The Illusion:

This is a daily chart of the S&P 500. The information most people will perceive from this chart is an illusion that will likely lead to high risk/low reward trading and investing. The illusion here is that moving averages (MA) somehow act as support or resistance. There are many conventional ways in which some traders use moving averages. These include using moving average crosses for entries and exits, measuring the slope of a MA for a "trend filter," or using a MA as support or resistance. However, the notion that MAs actually offer a benefit when used in these conventional ways is completely false. It is an illusion.
In the chart, a 20- and 200-period moving average are seen. These are widely used moving averages, both in the trading and investing community. Notice the slope of the 20-period MA at the areas labeled "B." The slope of the 20-period moving average is down in both cases suggesting a downtrend is underway. During this period, however, the low risk/high reward buying opportunity is greatest and right in front of you!
Those who use a MA as a trend filter would never buy when the trend is "down." This group of illusion-based traders and investors would likely conclude and say, "I don't want to buy now, the MA tells me this is a downtrend." The illusion created by using a MA to determine trend ensures you will ignore the lowest risk/highest reward opportunity each time it is offered. Furthermore, this illusion is likely to encourage a trader to take the opposite action of what the objective information (reality) suggests he or she should do.

Moving Averages Lag

MAs are averages of past data. They can only turn higher after price does. Let's focus in on the 200-day moving average. Specifically, notice the area "B" that is below the 200-day MA in the chart. Most traders and investors either see the 200-day MA on a chart, or hear about it from some financial news TV program. They perceive the mighty 200-day MA as some magical line that when crossed, suggests some valuable information. As we can see, waiting for prices to rise above the 200-day MA before buying ensures three things. First, risk to buy is high, as one would be buying far from the supply/demand imbalance. Second, profit potential is decreased. Third, those who wait until prices have crossed back above the 200-day MA to buy will likely provide profit for the reality-based trader/investor who bought at "B," the low risk/high reward entry area. The objective supply/demand imbalance is at "B," and the 200-day MA has nothing to do with it. When a moving average lines up with true demand or supply, the moving average will appear to work. Believing that the moving average actually has anything to do with a turn in price is an illusion.
The Reality:

Let's now explore reality through the eyes of objective logic. The areas labeled "A" are objective demand (support) price levels found on the daily chart. While these levels are not the best levels we find, we would still consider them to have more demand than supply. How can I claim they are objective demand price levels? Simple, while prices are trading sideways, supply and demand are in balance. In both instances, prices rose dramatically from those areas of perceived balance. The only thing that can cause a price rally from that area is when the supply and demand equation becomes "out-of-balance." In other words, there was much more willing demand at "A" than willing supply. The laws of supply and demand simply tell us this is true.
The areas labeled "B" represent the first time prices revisit these two areas of "imbalance." In other words, prices have declined to an area where there is more willing demand than supply. "B" is the low risk/high reward opportunity to buy, or where we expect price to turn higher.
Buying in these two areas ensures three important musts in trading and investing. First, your protective stop must be as small as it can be which offers a trader proper risk management/position sizing. Second, your profit potential, which is the distance from the entry to the supply area above, is as large as it will ever be for this opportunity. In other words, as price moves higher from the objective demand level, it is moving closer to the supply level (target) above, decreasing your profit potential. Third, the probability of success is highest because supply and demand are out-of-balance at that level.
The Lesson: Indicators and oscillators are nothing more than a derivative of price and volume. Price is all that need be considered when performing objective, reality-based analysis.

British Petroleum (BP) – Monthly Chart

Source: TradeStation


From: Mark H.
Sent: Tuesday, July 27, 2010 12:06 PM
To: Sam Seiden
Subject: RE: BP Trade long XLT
Hi Sam,
I sold my shares of BP yesterday @ 38.47 for a realized gain of eleven dollars. I'm doing an average of $800 a day now. I would like to personally thank you.

Thanks a ton,
M. Heber

The News

The Illusion:
The news illusion is the most powerful illusion in trading and investing as strong news leads to strong emotion (faulty beliefs). Most successful traders and investors have, at some point in their journey to consistent profits, fallen prey to this illusion. How many times have you seen bad news turn into a positive day for the markets? The thought of a major oil spill in the Gulf may have created the thought that oil prices would fall; that belief drove the majority to sell BP shares in the example above. Once the last seller sells at a price level where there is more willing demand than supply, the laws of supply and demand tell us prices rise.
Lesson: No matter how bad the news is, when the last seller sells at a price level where there is more willing demand than supply, prices rise. There can be no other mathematical outcome.

The Reality:
The area labeled "XLT Demand" on the chart represents an objective demand price level. We know this because price rallies strong from this level among other Online Trading Academy rules for identifying demand and supply levels. The area labeled "XLT Buys" represents the time when Online Trading academy Extended Learning Track (XLT) members were buying shares of BP. The news of the Gulf spill was very real, very bad, very awful and prices fell. However, once they reached the level where there was objectively more demand than supply, prices turned higher. This gave us our low risk, high reward, and high probability buying opportunity.
The Lesson: Strong news actually creates powerful turns in the market, opposite of what the majority expects because one side (buyers or sellers) exhausts itself into a price level where objectively, supply or demand are out-of-balance.

Fundamental Analysis

The Illusion:
In some cases, such as the chart of Intel Corp. (INTC) below, there are a number of illusions at work at once, severely clouding reality. INTC is a technology stock 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.

Not only is the answer no at the time of the earnings announcement, but the laws of supply and demand tell us we should be selling here, not buying. This earnings report, which invited the masses to buy, is given right into an objective supply area where the chart suggests supply exceeds demand. The eventual drop in price from this level is fast and strong for one simple reason. The number of willing buyers at this supply level became zero, while the number of willing sellers was still significant (supply/demand imbalance). The picture below was taken during a live trading and analysis session for Online Trading Academy graduates as I was setting up a short position with them and for them.
All this is information was available to us months prior to the rally and great earnings report. But most market participants didn't see it or care, as the illusions were too strong. Adding to the illusion was the uptrend, the higher prices advanced, the more people desired to buy into it. We are humans: There is comfort and safety in numbers.
"Last night, Intel (NASDAQ: INTC) said quarterly earnings quadrupled to 43 cents per share, topping the consensus view of 38 cents per share. Revenue rose 44% to trump forecasts as technology spending has increased among consumers and corporations." - AP

Live Online Trading Session – April 15th

INTC Reaches Profit Targets

Again, many illusions come into play in this example. The illusion-based trader saw a low risk/high reward buying opportunity at the supply level, while at the same time, the reality-based trader (us) saw that same opportunity as a low risk/high reward shorting 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 sellers than buyers, 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 sold short. Many illusions, however, invite the masses to buy at the absolute worst time and there is a reason for this...
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:

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 we 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 don't 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.

Act Like A Goose

The human mind is not wired to trade properly. Our decision-making process is not like most other animals. Most people don't focus on reality when deciding to take action; we make decisions based on emotion, not intellect. Not only is it very difficult to live in complete reality, but consistently making actions based on reality is an even harder task many times. A goose, on the other hand, would make an excellent trader and investor. When autumn approaches in the north, the geese don't wonder if winter will come or not. They certainly don't call a goose meeting to figure out a way to stave off winter. They simply act like a machine and fly south for the winter and repeat this process each and every year flawlessly for their entire life, without questioning their choice.

Throughout history, people that pioneered original reality-based thought on certain topics often paid for it with their life. An example that comes to mind was the crazy thought that the world was round. Though your life is certainly not in jeopardy with illusion-based trading and investing, the growth of your hard-earned capital sure is.

The Three Laws of Price Movement

I have been involved with trading and investing for more than ten years, and the consistent low risk profits I have produced are a function of trading what is real, not what I feel. I eliminate subjective emotions by basing each and every decision on a simple mechanical set of objective rules that quantify supply and demand. These simple rules, which are beyond the scope of this article, stem from three laws of price movement I crafted long ago. These three laws form the foundation upon which the whole system of proper trading and investing lie.
Laws of Price Movement:
1. Price movement, in any free market, is only a function of an ongoing supply and demand relationship within that market.
2. Any and all influences on price are reflected in price.

3. The origin of motion/change in price is an equation where one of two competing forces (buyers and sellers) becomes zero at a specific price.
A successful trader's path must be reality-based, not driven by illusion. The reality is that markets are nothing more than pure supply and demand at work; human beings reacting to the ongoing supply/demand relationship within a given market. This alone, ultimately determines price. Opportunity emerges when this simple and straight-forward relationship is "out-of-balance." When we treat the markets for what they really are, and look at them from the perspective of an ongoing supply/demand relationship, identifying sound trading and investment opportunities is not that difficult a task. At Online Trading Academy, we do not prescribe to the school of conventional technical and fundamental analysis. Furthermore, we do not prescribe to the school of conventional thinking because we are not interested in conventional results. We simply prescribe to the school of reality-based thinking. In trading and investing, those who view the markets through the eyes of reality, simply get paid from those who don't. To those people who are big fans of conventional technical analysis, please don't send hate mail. We still love you and wish you the best results in achieving your financial goals. I know much of what I am writing here flies in the face of what is written in almost every trading book. This piece is meant to help offer everyone a more complete perspective on how the markets really work.