Your Econ Professor Lied to You

Stocks are once again caught in a vicious chop this week as emerging geopolitical strife throws new wrenches into the market’s gears.

No, we’re not tumbling into the abyss. In fact, I would characterize what we’re seeing as a normal pullback. The averages marched off their lows and didn’t look back during the entire first half of the year, with many stocks continuing higher into the late summer. It was an easy time to find snapback runners and other strong trends.

Yet all good things must come to an end. Fall is in the air – and cracks have appeared in the markets. It’s not time to sound any alarms. Not yet! Stocks are caught in a typical seasonal pullback at the moment. Nothing more, nothing less.

As I’ve mentioned before, I’d be more concerned if stocks didn’t take a break this fall. If we’re hoping for any type of year-end melt up, we need a fall pullback to help set the table for the impending rally.

But let’s not get ahead of ourselves…

We won’t have a clear path until the averages bounce. Or, if the bears have their way, we finally crack below key levels. The best move is to sit on our hands until the market offers us some clarity – one of the most difficult tasks required of traders and investors.

It might feel like you aren’t doing anything constructive when you aren’t buying or selling. But this couldn’t be further from the truth. Messy market conditions give us an opportunity to review past trades, reassess our strategies, and plan our next moves.

These choppy markets have allowed me to tell you a little bit more about my story, how I found trading, and how you too can learn to think like a trader to improve your market returns – and even change your life.

Over the past couple weeks, we’ve discussed some core trading principles…

I’ve noted that successful traders take advantage of opportunities when they present themselves – long or short.

We also talked about how traders don’t have to tie themselves to a wall of glowing monitors to make money. Yes, it’s possible to buy and sell just a couple times per week, if that. Profitable traders can have lives outside the market, attend their kids’ soccer games, and even take off time during normal market hours. Imagine that!

We discussed how profitable traders need to reject the idea that fundamental company information has any predictive power over short-term price fluctuations. Fundamental and economic analysis is undeniably important in the long-term – but it’s useless for attempting to determine when to buy or sell stocks.

Finally, a trader must learn that he can’t obtain a secret edge in the markets. There’s simply no special information that can give us an advantage over the pros or help us predict the future.

Price is Truth

I know some of these revelations might be hard to swallow. After all, it goes against everything we were taught in school.

If you’re a slow learner like me, it might take you years to come to these realizations. But the sooner you can accept these core trading concepts, the quicker you can begin booking consistent profits.

That brings us to strategies. If we accept that thinking like a trader is the only way to consistently make money over any timeframe, how can we begin to put these ideas to work in the real world?

The first step is a complete reliance on price. A trader insulates his mind from the news and hype, opting instead to focus on price action and other irrefutable facts.

Why is price irrefutable? As legendary technician Ralph Acaompora explains, unlike earnings, price is never restated. If a stock closes at $50, that is the closing price on that date forever. End of story. There is no debate as to the price of a security at any given moment. The quote is the quote.

This means we can accurately plot a price chart over any timeframe. Thanks to the marvels of modern computing, this requires no research or skill whatsoever. We simply pull up an interactive chart from our brokerage trading platform, or any other stock market research site of our choosing.

Price is at our fingertips over any timeframe we choose.

The “Magic” is in the Charts

Charts are a trader’s best friend.

Unfortunately, too many trading tourists think there’s something magical about the lines we draw on these stock charts.

Of course, this is completely false. I can attest that there’s no alchemy involved in plotting lines on a chart. These lines simply connect price points of interest. Since price is never restated, we can use our price charts to pinpoint areas where large groups of traders and investors have exchanged shares. That’s important information!

If price is churning sideways and continues to get rejected every time it rallies toward $50, we can assume this is an important price for this particular stock. This is an area where shares have exchanged hands on multiple occasions, and the stock is running into sellers every time it teases these levels.

If our fictional stock finally moves above $50 after multiple attempts at this area over a significant amount of time, this tells us that the sellers have been overrun by more aggressive buyers, which typically leads to a strong move higher.

Now, you have a situation where anyone who bought shares at $50 is more reluctant to sell as the stock moves higher. Why would they sell now? They’re showing strong gains! That creates a snowball effect, leading to a fast move higher as fewer eager sellers can drag the price down.

This is what happens when a stock breaks out – it clears a level that has acted as resistance and is moving into blue skies. No magic required!

If we are able to find and harness these breakouts, we can buy a stock just as it’s making a strong move higher. The fundamental reasons for the move – if any – simply don’t matter. All we have to do is play the percentages.

Some breakouts fail. Some market conditions aren’t as conducive to trading them. But over a long enough timeframe, the odds will work in our favor if we’re managing our risk properly.

To be continued…

The Daily Reckoning