Armed with the latest trading tools, trading systems and assorted gadgets, like electronic gunslingers today’s traders ride into the markets ready for action, but often are carried out feet first with busted trading accounts because they lacked an understanding of one fundamental principle: the general stock market direction.
You can be right about every factor of stock selection, but if you’re wrong about the overall stock market, you still are likely to lose on what’s otherwise a solid buy. No matter how good the stock is for buying or the how bad the stock is for short-selling, the odds are against you being successful. On average, 75% to 80% of all stocks will either rise or plummet along with the general market. This scenario was the cause of many losses in the market crashes of 2000 and 2008.
The good news is, you only have to learn to observe the broader market and adhere to what it is trying to tell you. Unfortunately, most traders confuse predicting the market with timing the market. This is an important secret to successful trading that many get wrong.
Predicting the stock market usually starts off with the wrong question: “What is the market going to do?” This question leads you to start trying to pick tops and bottoms. This approach is usually the result of listening to all the “experts” on cable TV who muse over what future direction the market is going and from what point it will begin its rise or fall.
This leads traders to try to trade off these tops or bottoms, but that is a heartbreaking activity. Rarely are they right and the few times they are, it doesn’t generate enough profit to make up for being wrong the other 70% of the time. It costs them time and emotional well-being.
The first thing to do to avoid falling into this trap is to better understand how big general market indexes move and are influenced by the traders who trade them.
STOCK MANIC DEPRESSION
The markets have moments of incredible euphoria and then, almost in the blink of an eye, despair and hopelessness. These extremes also are contagious to those who are trading them. They can lead to trading paralysis, a state of inaction that often comes at precisely the wrong time: just as the markets begin to turn in their favor.
When the markets are healthy, and the future for the economy looks bright, the market is bullish and happy. For traders caught up in these moves, caution often is moved to the wayside. Unfortunately, as night follows day, markets eventually reverse before market participants know what’s coming. Most never consider that it may be time to lock in gains or protect a position. Like addicts who cannot admit their addictions, these traders turn a blind eye to it being time to leave the market for the safety of cash.
The result of being on the wrong side of the eventual crash is, for most traders, a sense of despair and hopelessness as they hold on during every decline, hoping that every short-term rally is the return of happier days. Instead, the markets become more financially depressed, rewarding the bullish faithful with holdings valued at a fraction of what they once were worth.
DON’T BE AVERAGE
Average investors allow themselves to fall victim to this situation because they come into the market with no plan or method to trade. They buy on tips from their brother-in-law or because a stock is reputed to be a “good company.” These are not plans or methods. This is gambling.
For the skilled trader, there are tools that when combined with sound reasoning will serve as a guide on the Road to Mastery. These tools help the skilled trader avoid the emotional and financial extremes experienced by the herd; instead of being a victim of the manic behaviors of crowd psychology, you can exploit these extremes.
While these tools will help you make solid decisions, it is still hard to go against the crowd. Steel your emotions to act on reliable signals and discipline yourself to follow your rules. Crowds are often wrong. Being a follower in the markets usually leads to losses. This is harder than it appears because human beings are social animals, but by exercising self-discipline, we can move ahead of the curve.
This implies that successful trading requires the ability to act independently. Having a method or system that allows you to exploit an advantage helps, but ultimately even the greatest trading method won’t work if the trader ignores certain
underlying truths.
One solution is to use a trading tool that, by its nature, not only captures the short-term market moves but tends to give positive signals in line with the general market trend. While this seems at odds with what we just said, there is a difference between following the trend and following the general market consensus. Trends give signs of exhaustion before the larger trading community takes notice.
FOLLOW THROUGH DAYS
Bear markets usually end while business is still in a downtrend. The reason is that stocks are anticipating, or discounting, all economic, political and worldwide events months in advance. The stock market is a leading economic indicator, not a lagging indicator. As such, this is an excellent time to get on board. Not only are you getting in ahead of a big move, but you generally are doing so in concert with the general market trend before most of the investing public has picked up on it.
One of the best methods for spotting the bottom in the stock market is the O’Neil Follow Through Day (FTD). This method uses a combination of price action combined with volume to spot the bottom in the general market. It is based on statistical studies of the market going back almost 100 years.
At some point in the decline of the general market, it will attempt to rally. A rally attempt begins when a major market average closes higher after a decline that happened either earlier in the day or during the previous session. An example is if the S&P 500 falls 2% in the morning but then recovers later in the day and closes higher (see “FTD gives green light,” above) .
Now that a rally has been attempted, starting on the fourth day following the attempted rally, look for one of the major averages to follow through with a huge gain of at least 1% on heavy volume. An FTD should give the feeling of an explosive rally with what appears to be strong and decisive price action. The volume for that day should begin above average, as well as higher than the previous day’s volume.
The most powerful FTDs occur within four to seven days of an attempted rally. Occasionally, a FTD will occur on the second or third day, but in that scenario the first, second and third days must all be quite powerful, with a major average up 1.5% or more each session with heavy volume.
In general, larger averages, such as the S&P 500, are better proxies for the overall market than, say, the Dow Jones Industrial Average, which is only composed of 30 stocks.
GO EASY
A FTD doesn’t mean to go on a buying spree, but it does give the signal for intelligent speculation where you, as a trader, use a complimentary method of stock selection of high-quality stock candidates to begin hunting for good entries.
Also, no new bull market has ever started without a strong price and volume follow-through confirmation (see “The big move predicted," right). It pays to wait and listen to the market.
Spend time studying your charts and the market averages to perfect this. Practice is the best way to learn the mechanics of this or any method.
To be highly accurate in any pursuit, you must observe and analyze the objects themselves carefully. By studying this method in action, you will have a very powerful tool in your trading arsenal.
Note: For more on this method, see “How to Make Money in Stocks” by William O’Neil (Chapter 9).
Billy Williams is a 20-year veteran trader specializing in momentum trading in both stocks and options. Read his market commentary at www.StockOptionSystem.com
