The one thing all investors and traders must do

A couple of weeks ago, I ran you through a successful short-term trade (in real time) in the FTSE 100, which beautifully illustrates a bedrock principle for achieving success in the markets.

This principle applies to anyone, whether you are a short-term spread better, or at the other extreme, a buy-and-hold share investor. And it’s one that I will explain to you here.

Having observed the financial markets for more years than I care to measure – in fact, I started in the pre-personal computer age – I can honestly say that the character of today’s markets has not changed one iota.

Yes, we have more technology, but the markets themselves have not changed.

This is because the participants are still human – and human nature, if it changes at all, does so over huge time spans.

And it is humans that have always made the buying and the selling decisions that determine prices.

Going back to my FTSE trade, I started the trade by taking a bearish stance, and was looking for a place to short. I had my reasons for this – and they were all based on my tramline method, plus the Fibonacci and Elliott wave principles.

But I also had a ‘secret ingredient’ – the knowledge that the vast majority of traders/money managers/economists/commentators are uniformly bullish – in fact, most of the measures I follow were off the scale.

Trading with the crowd results in losses for most

With opinion so one sided, and prices so elevated, the odds favoured at least a significant correction. Why? Simply because most of the buyers were already in the market. So all it would take is a small round of profit-taking to set off a heap of protective sell-stops by the most recent bulls.

This is a point not recognised my most investors and traders. Most become more bullish as prices rise, whereas they should become more bearish. Remember, as prices rise, they get closer to the inevitable down-turn.

That is a tough attitude to adopt – it takes guts to go against the herd. It also goes against our most basic urges – safety lies in numbers after all.

Imagine you are a gazelle in your herd and you are following the leader looking for a water hole. The rest of your herd is happy to tag along, because that is what herding gazelles do. But you think you know where there is one off in a different direction.

However, if you break away, you will expose yourself to being picked off by a lion. So, what do you do?

This is the kind of dilemma most investors and traders face when they think about trading against the trend – although not as life-threatening, I hope.

Don’t dismiss the role of emotion in trading

So you can’t dismiss the power and role of emotions when trying to time markets. Action based on such emotions results in an individual’s trading decision. Indeed, I believe all investing/trading decisions are made emotionally, not rationally – including mine.

Going back to my FTSE 100 trade, note that my first attempt failed (although I suffered no loss, as I used my break-even rule).

But I spotted a second opportunity and entered a short trade for a second time.

Now, many traders would not have done this, as they may have suffered a loss on the first round. They would be ‘gun-shy’ for another trade in the same market.

Such a decision would have been entirely understandable. It’s based on a universal emotional response to the loss, which most of us would have, not on a realistic assessment of risk/reward on the second trade.

We would believe that since we lost on the first round, the risk on another similar trade would be high. We do not wish to feel foolish making the same ‘mistake’ twice, do we? Once is bad enough.

Rationally, this is nonsense, of course. Say you flip a coin. You guess ‘tails’ and it comes up ‘heads’.

Do you stand a better chance of being correct if you guess ‘heads’ the next time? Of course not.

Each flip is a separate event and has a 50/50 win chance.

So it is with the markets, which do not care whether you exist or not!

So, by having a negative emotional response to a loss, many traders would have missed out on the successful second trade. They may even decide to pack in this game altogether!

Now, one of the main reasons many lose by trading with the herd is not that they fail to spot a trend – which can be very profitable – it is because they do not know when to take profits when the trade becomes ‘crowded’ with too many herd-followers.

Training your mind to look for against-the-herd trades is not easy, I know. It took me several years to really get into this way of thinking.

But by not following your initial basic emotional reactions, you can put yourself in front of some powerful moves. And who knows, you may be able to do the virtually impossible – buy low and sell high (and vice versa)!

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