From the January 01, 2010 issue of Futures Magazine • Subscribe!

Understanding stock market direction

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.

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