Stock Trading Psychology: Adapt Or Die

Darwin’s theory of evolution applies equally as well to traders on Wall Street as it does to beasts in the jungle. The difference, though, is while it may take a lion dozens of generations to adapt to changes in his environment, a trader must change within days.

The biggest environmental change on Wall Street over the past year has been the growth of high-frequency trading (HFT) - the use of computerized algorithmic trading programs to generate daily profits. HFT programs have the ability to “trick” other computers into executing buy and sell programs. This interrupts the natural ebb and flow of the market, and it creates exaggerated moves in both directions.

Think about it this way…

Let’s say you have an unlimited supply of money and you know many traders are looking at a specific technical indicator to trigger large downside bets. It’s in your best interest to push the market to trigger those large bets and then run the market higher - forcing short sellers to cover at a loss and push prices even higher as they buy the stocks back.

Conversely, if you know everyone is looking to buy at a certain level, then why not push prices to that point, let everyone buy in, and then run a bunch of sell programs to force everyone out of position?

It’s not really market manipulation. It’s more like the guy with the most money at the poker table bluffing on every hand.

For the past several years, I’ve made a pretty good living by using a variety of technical indicators to predict important reversal points in the market. Last year, for example, was perhaps the best of my career. My readers and I made most of our profits betting on the upside. In other words, in the midst of the ugliest bear market we’ve seen in our lifetimes, we made money buying stocks.

But things started to change back in February. Rock-solid technical indicators that had previously always indicated a market bottom weren’t working. Stocks continued lower. The change was evident shortly after February 26, when I declared “Short Sellers Are About to Get Wiped Out.”

Stocks continued sharply lower for two more weeks before finally hitting bottom and reversing higher. The trading range was extended. Indicators that used to work all the time without fail weren’t working with the same efficiency. It was the first clue the environment was changing.

Fast forward to two weeks ago…

All of the indicators I’ve used to short stocks successfully over the past several years were screaming, “SELL!” Yet stocks have continued to run sharply higher, and the indicators are now screaming even louder.

Here again, the trading range is extended. This is the result of the influence of high-frequency trading. Traders must evolve to profit in the new environment.

We have to get used to even more extreme oversold and overbought readings, and we have to wait until price action confirms a reversal in the trend rather than trying to anticipate it.

Consider the following chart, for example…

This is a chart of the S&P 500 (^GSPC) plotted against its “slow stochastics.” The chart is overbought when stochastics stretch above 80 and oversold when they drop below 20. The circles indicate the most recent overbought readings - all of which were followed by quick but shallow drops to oversold levels… except the last one.

The indicator hit “overbought” status in mid-July, stayed there for a remarkably long period, broke below the “80″ level (which should have sparked a selloff), and has since bumped back above 80 again.

This is a remarkable pattern. It signals the trading patterns of yesteryear no longer work like they used to. They are valid in the long term, but the short term is questionable.

So it’s just like late February. Indicators are at extreme levels, but price action doesn’t support going against the trend. Not yet, anyway.

This is where evolution comes into play.

Every indicator I follow says to be short this market. That has been the case for the better part of the past two weeks. And it has been the wrong strategy - for now anyway. So rather than using technical indicators to predict a reversal in the market - a strategy that worked wonderfully for the past few years - traders now need to exercise patience.

We have to wait until price action confirms a change in trend, then we have to be willing to hold a position longer than usual.

As I wrote last week, it’s no longer two steps forward and one step back. It’s more like 100 steps forward and 20 steps back. Jump in too early, and you’ll get run over. Jump out too soon, and you’ll leave a boatload of profits on the table.

Get used to extended trading conditions. That’s the environment were in right now. Smart traders will adapt to it. Stubborn traders who stick to their old strategies will die.

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Comment by Kiwi

2009-08-06 19:41:10

Observed similar changes in Forex from about the same time.
Many reliable indicators now give false readings and normal chart entry points became traps. Good to hear confirmation and an explanation thanks.

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Comment by Stock Trading Tips

2009-08-07 18:02:17

The fact remains that a guy who can successful dictate how things are done is not just one with the biggest cash but one with good knowledge of investment backed with a big cash.

So my candid advice is learn your environment,the strength of the big players and guess what………….beat them to the game

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