Category: Your Money

The Psychology of Technical Analysis: Ch. 8

PTAGreed is the fear of missing further profits.

The objective of a crowd in the stock market is to influence prices: the bullish crowd will try to force prices up while the bearish crowd will try to force prices down. The sentiment of the crowd usually turns prior to price reversals. Hence, just before market peaks, sentiment will begin to deteriorate as the percentage increase in price falls.

The price-sentiment limit cycle is prone to shocks. Shocks occur because of a sudden divergence between current price movements and expected price movements. Shocks can be either pro-trend or contra-trend. Pro-trend shocks almost always destroy the unsuccessful crowd. However a contra-trend shock will initially cause prices to fall which results in falling sentiment. Eventually, the fall in prices begin to slow and encourages bear closing. This, in turn, causes prices to rise and hence a reversal in sentiment.

The disintegration phase of either a bull or bear cycle will occur very quickly. The fear of not making profits is of a different order of magnitude from the fear of actually losing money. This implies that investors prefer to hold stock rather than short positions. The long-bias means that when a bear market begins, not only do very few investors anticipate the fall, but also there is very little resistance to falling prices. Therefore, bear phases take a shorter period of time and are steeper than bull phases.

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The Psychology of Technical Analysis: Ch. 7

PTAWhen an individual buys or sells securities, an emotional commitment is being made.

The battle between the bulls and the bears is what creates a market for securities. Without the presence of this constant state of conflict, there would be no graduated price movements: prices would jump up and down randomly and no one would trade.

When an investor buys/sells securities, he accepts one of the two crowds’ beliefs about the future trend in prices and identifies strongly with other members of the same crowd (there are exceptions to this, however they form a sophisticated niche). An investor is a committed crowd member. Because of this, as a price trend develops, individual trading decisions become increasingly non-rational. Ultimately, extremes in optimism or pessimism occur, creating the conditions for a reversal.

The objectives of technical analysis is to keep a close watch on what other investors are saying and doing and when a vast majority are saying and doing the same thing, do the reverse. The more people who believe in a trend, the fewer people there are left to perpetuate it.

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The Psychology of Technical Analysis: Ch. 6

PTAA technical analyst knows the price of everything and the value of nothing.

The Rational Expectations Hypothesis is based on three interlinked assumptions:

  1. Individuals do not behave irrationally
  2. Individuals learn from their mistakes
  3. Individuals arrive at their decisions independently of one another

However, REH fails in the real world. Natural forces encourage people to herd together as groups. Groups behave as single organisms that respond in predictable ways to new information, have their own emotional cycles and follow a definable path of growth and decay. This is the rationale for technical analysis.

Technical analysis assumes that prices reflect the entirety of investors’ expectations of the fundamentals (both economic and company specific). Financial markets will always be trying to anticipate the future and hence market prices precede changes in fundamental conditions. And most importantly, each price movement is mathematically related to preceding price movements.

Read the review of the first few chapters here.

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ETFs are extremely profitable…

… for the banks that make them.

Synthetic ETFs may actually be the most profitable type of fund around, generating an average gross profit margin of 69% for their issuers, compared to physically replicated ETFs, that generate an average gross profit margin of 64%. Much of these profits are delivered via ancillary activities like securities lending, securities finance and swaps. The money is being made elsewhere. Outside of the view of ETF clients. Clients are in fact unwittingly providing capital for banks’ ancillary (and risky) ETF-related activities — while, incidentally, being directly connected to the risks that are being generated.

Read more here: http://ftalphaville.ft.com/blog/2011/07/11/617516/if-you-pay-peanuts-for-etfs-you-get/

and here: http://www.indexuniverse.eu/europe/opinion-and-analysis/7904-etf-providers-earn-double-funds-management-fees-says-deutsche-bank.html?Itemid=126

The Psychology of Technical Analysis: Ch. 2- 5

The Psychology of Technical Analysis: Profiting From Crowd Behavior and the Dynamics of Price

Evolution is the unfolding of order and complexity in the process of learning.

Aren’t investors supposed to behave rationally at all times? What is the reason behind seemingly intelligent and rational individuals caving in to heard-instinct? The simple truth is that membership of a crowd causes people to behave differently from the way that they would in isolation.

In fact, herd-instinct is hardwired into our brains. Our brain stem (the innermost part of the brain) that is primarily concerned with instinctive behaviour, developed over 250 million years ago, compared to our neo-cortex (which allows us to be aware of the thought process itself and to anticipate the future/recreate the past) that developed only during the last 50 million years or so. The operation of the neo-cortex is all too easily suppressed by the emergence of a crowd mentality. As the crowd comes into being, the brain stem and the limbic system hold sway.

Membership of a crowd involves the abrogation of personal responsibility to some degree. A crowd tends to behave in a non-rational way and forces its members to do the same. For most people, some form of crowd pressure provides a major motivating force in their social, economic and political activities.

So in essence, a crowd is a self-organized entity defined by a common purpose. Once a crowd is formed, it will react to new pieces of information from the environment. Feedback loops are created and leaders emerge. The feedback loops create stable fluctuations (limit cycles) in the relationship between the crowd and the environment. These limit cycles are subjected to shocks and the crowd readjusts to deal with unfamiliar events. Understanding limit cycles and the readjustment process is key to understanding and predicting the the overall behaviour of the crowd.

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