Insights into Technical Analysis - Majority Effect

I first started to trade using technical analysis. Being trained as an engineer, statistics and chart reading is a much easier and faster way for me to learn to trade compared to looking at financial numbers. Secondly, without proper education in investment and in addition to the many "trading" books that I read and seminars that I have attended, the negative information about "investment" using fundamental analysis convinced me that technical analysis is a faster and more effective way of earning money in the stock market. Like most traders, because of my eagerness to profit from the stock market or you may also say my struggles not to loose money to the stock market, I just apply what I have read and learned from the so call "experts", without deeper thoughts and analysis with skepticism. Maybe, a series of discussion of my thought process to understand Technical Analysis, will help to structure my understanding of a preferred investment approach.

 

Like some of my previous blog, I always like to start the discussion of a topic with the definition of the term or topic of the discussion. It will always help to put everyone on the same footing before any further discussion. "Technical Analysis" according to Investopedia is defined as a method of evaluating securities for forecasting the direction of prices through analyzing statistics generated by market activity, primarily prices and volumes. It uses charts, indicators derived from prices and volumes, and other tools to identify patterns that can suggest future activity. I found the analogy on "Technical Analysis" and "Fundamental Analysis" described by Investopedia enlightening. Taking an example of buying a product in a shopping mall, fundamental analysis would go to each store and study the product being sold and then decide whether to buy it or not. By contrast, a technical analyst would sit on a bench in the mall to study the people going into the stores and decides to buy the product based on the patterns or activity of people going in each store. 

From this analogy, the decision to act is purely based on the majority behavior represented in the form of an indicator, ratio or a pattern formed after a period of time.  Almost all of these representation are defined by the Open, Close, High and Low Price and the Volume of transaction which can be measured down to tick level.  It is this "majority effects" that causes the volatility in the price movement. "Majority effects" can be generated genuinely by institution buyers who believe in the value of the stock. But realistically, a lot of these "majority effects" are initiated from rumors or "experts" opinions that drive the greed and fear in the market. On the hind side, "majority effects" can also be generated by "powerful" speculators who has the resources to get real time market data to induce "false" perception in the market through highly sophisticated programs and powerful computers. 

Knowing this important characteristic of "Technical Analysis", the question is whether are we able to trust the majority totally without knowing the value of the product you are buying before you put your hard earned money into the stock market. Are you comfortable buying something purely because majority is buying, without checking out the quality of the product? What is the chances that you will be able to catch the turn of every start of a "majority effect" given the limited resources and information that most investors have?

The Key Differences Between Investing and Trading

Having highlighted the misunderstandings of investing and trading in the previous post, the market seems to have vaguely redefine "investing" and "trading" with some additional characteristics so as to differentiate the two. 

In fact, from the very same source where I extracted the definition of the two terms, Investopedia, it describes the differences between investing and trading as follows:

"Investing"..."The goal of investing is gradually build wealth over an extended period of time through the buying and holding of a portfolio of stocks and other investment instruments.....Investments are often held for a period of years, or even decades..."

"Trading"..."involves more frequent buying and selling of stocks,...to generate returns that outperform buy-and-hold investing...."

Since there is no market standard of how long an investor or a trader have to hold on to their position, we cannot clearly differentiate investing and trading using holding period of the portfolio.  The key difference I see in these two different styles are:

"Investing" expects a profit that generates from the potential of growth (sometimes includes dividend growth) of a stock or market. In order to estimate the potential, "investors" analyze current and past fundamentals performance of the security to determine potential future growth. Since growth cannot be obtained overnight, "investors" need to hold on to the security for at least until the next financial report or upon a confirmation of a news that will change the growth potential drastically, to determine if the estimation is accurate before deciding to exit the position. Although all investments carries certain level of risk, using fundamentals to analyze the market reduces the risk in the long run, as past fundamental performance is a more tangible information to determine potential growth which results in profit for "investors" as compared to using behavioral study approach of technical analysis. Some of the most well known investors are Warren Buffet, Peter Lynch, Philip Arther Fisher, just to name a few. 

"Trading" expects a profit that generates from the volatility of the stock or market. In another words, their intention is to profit from the natural cyclical behavior of the market caused alternative force of supply verse demand and greed verse fear. To put it simply, "traders" generates their profit through buying at a lower price and selling at a higher price or vise-verse for selling short.  There is minimum or no reliance on past fundamental performance of the security, for the key is the ability to time the market by studying the behavior of the market relying heavily on price movement and volume of transaction (both buy and sell, even at tick level).  "Traders" believed that the behavior of the market can be reflected on technical charts derived from the price and volume data obtained on a specific period of trading and with the help of indicators calculated, also from the price and volume that supposedly shows the momentum and oscillatory characteristics of the trade in that period.  Since, "trading" derives its profit from the cyclical behavior of the market, "traders" do not have to wait for a long time to materialize their profits, thus the period of "trading" is generally shorter so that "traders" can maximize their gains from the multiple ups and downs of the market cycle. Unlike "investors" who ride through both the ups and the downs cycle, "traders" can also take advantage of the down cycle to take profit by "selling short". Some very well-known traders are Jesse Livermore (1877-1940), William D. Gann (1878-1955), Richard Wyckoff (1873-1934) and those who are still alive, George Soros, Jim Rogers and many others. 

So, the key difference in style between "investing" and "trading" is the philosophy of how each of them makes investment decisions. An "investor" makes the decision to invest base on the potential return of investment of a firm by analyzing the current fundamental performance which shows the current health of firm and past fundamental results which supports the assumption of future growth.  A "trader" makes the decision to invest by analyzing the behavior of the market from pass price and volume movement and repeated patterns to time the entry and exit into and from the market. 

Each of these investment styles has its strengths and weaknesses. We may discuss about them in the next post. 

Misunderstandings of Trading and Investing

I have attended numerous seminars on trading and investment. Whenever I was in a trading workshop or seminar, traders will always say something negative about investment and likewise, for investors on trading. I noticed that there is a very big misunderstanding about the concepts of trading and investment. I found it particularly disturbing on how entrenched they are in their respective beliefs and their reluctance to understand and accept the fact that both groups are actually participating in the same act for the same purpose and intention. Well, maybe I thought I should try structure our thought process with the intention to help make both parties less bias towards their beliefs.

Misunderstanding # 1 - Trading is not investing

A lot of investors try to avoid being associated with traders and likewise traders with investors.  Is trading totally interpendant from investing? According to Investopedia, the definition of each term is as follows:

"Investing" is defined as the act of committing money or capital to endeavor (a business, project, real estate, etc,) with the expectation of obtaining an additional income or profit.

"Trading" is defined as a basic economic concept that involves multiple parties participating in the voluntary negotiation and then the exchange of one's goods and services for desired goods and services that someone else possesses...In financial markets, trading also can mean performing a transaction that involves the selling and purchasing of security.

From these definitions, in order for an investor to buy a stock in the company, a transaction must take place between the "investor" or a "trader" and a willing seller of the company's shares who can be the owner of the company or someone in the market that holds some of the company's share (open market).  In another word, "trading" is part of the process of "investing". In a nutshell, "investors" must trade in order to participate in the investment opportunity and technically, "traders" share the same objective as "investors" where both commit their money or capital to endeavor a business (buying a stake of the company) with the expectation of obtaining a profit in the future.

 So, if you are an "investor", don't say you never trade and if you are a "trader", don't say you don't invest...for these two terms are a subset of each other. 

Misunderstanding # 2 - Investing is Long Term & Trading is Short Term

Another very common view point used to differentiate investors and traders is the length of time one holds on to his security before selling back to the market.  Fiancial market participants with the intention to make a profit in a very short term are generally known as "traders". In contrast, those who participate with the intention to make a profit in a longer term are known as "investors". Unfortunately, there is no single market standard period of investment for each case. "Traders" can hold onto a position between seconds (down to milli-seconds for auto-trading) and up to a few years (for trend trading).  "Investors" can hold onto their investments from as low as a few days to decades. You will notice that there is a very huge overlap between them where traders spent as much time holding to their position compared to investors.

If we take reference to the definition of investing and trading, you can also see that the amount of time holding on to the investment is not a factor in differntiating them. Therefore, there is no rules that "traders" cannot hold a trade "long" term, nor is there any to restrict "investors" from holding their investment "short" term. Furthermore, "long" or "short" term is subjective relative to the investor or trader.

 Therefore, we cannot say one is an "investor" just because he or she is holding a trade longer then days or months, neither can one be called a "trader" when he or she decides to sell the trade a day after it is bought. 

Misunderstanding # 3 - Investing is better then Trading or Trading is better then Investing

There is a classic saying, "All roads lead to Rome". But we also need to understand, some roads will take longer to reach there.  Having said there, we also need to understand that not all road is suitable for everybody.  There are roads that are lest risky but requires patience and takes longer time reach the destination, and there are roads that are riskier but need a shorter time to travel. Most importantly, we must also know that not all people who travels will reach the destination.

Just like the journey to Rome, there are also many ways in the journey of financial trading or investing.  Which route to take depends on many factors, for example capital, amount of time available to spend on analysis, risk tolerance, expected return of investment and capital turn over rate. Different investment style is required for different people as their constraints, needs and the adaptability to the investment style are different..

Thus, I believed that there is no one perfect investment approach, but there is one or a combination of several investment styles to match the character and meet the contraints and requirements of an investor.

Objectives of GiFT.investor Blog

Every financial trader or investor has his or her own experience in his or her own journey in trading or investment. Some have chosen to share their experiences of success and failures, and others chose to keep the experience to themselves. Some very successful ones, like Warren Buffet, William J. O'Neil, Peter Lynch, just to named a few shared with books that they authored themselves or written by someone else. There are also thousands in the financial marketplace who chose to share their experiences in newsletters and blogs. Like those who shared their experiences through blog, GiFT.investor blog is a sharing site created within GiFT Ministry blog primarily to share our financial and investment journey as we joined God in His work in the financial trading marketplace.

Initially, the idea of writing experiences, thoughts and opinions through GiFT.investor blog is to help me structure my thoughts based on my passed experiences in financial trading and investments and also based on the information and knowledge that I gathered from readings and seminars. These thoughts are also heavily influenced by my spiritual belief and faith. It is important to note that I am not an expert in investing or trading, comparing to most of you and do not claim that my sharings or ideas are any better then those who will be reading and sharing in this blog. It is also important to note that there may be different ideas, strategies, opinions and investment styles that many of us have, which are derived from each of our own investment and trading journey through interpretation of information that we accumulated through reading of books and the experiences that we gathered from real life financial trading and investment.  Thus, I do not expect all who read GiFT.investor blog will see eye to eye in everything we shared in the GiFT.investor blog.

GiFT.investor blog is an extension to GiFT Ministry blog. The purpose is to provide a platform of sharing in our work in the trading or investment marketplace. Hopefully, through these sharings, we are able to learn from each others' differences and experiences, so as to serve the God's purpose of financial trading and investment...to be "Salt and Light".