The Art (and Science) of the Trade

Meir Barak |

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Stock trading is not an exact science. If it were, it would be handled by accountants. No method is complete in and of itself. Even if you learn a 300-page manual on technical analysis by heart, I can assure you that you'll still lose money. The winning recipe is a combination of winning components. The question then becomes: how do I proportion the components? That differs from one execution to another, from one stock to another, from one set of market conditions to the next. Getting the proportions right is, in fact, the art of trading. That’s why I believe stock trading is a fascinating mix between exact science and art.

There are four ways to reach a decision on how to trade stocks:

  • Technical analysis, which is how traders operate
  • Fundamental economic analysis,the method for long-term investors
  • Random walk, the mode of operation for those who claim there is no method
  • Gambling,the method used by the public which thinks it’s found “the formula” for turning a profit

Who’s Afraid of Technical Analysis?

Sometimes the very title of a specific field causes people to fear it and feel alienated from it without even knowing the components of that field. Too often, this is the case with the phrase “technical analysis.” 

Technical analysis is based on observing past behavior for the sake of predicting the future.

The words “technical” and “analysis” both suggest something complicated, but in reality technical analysis is simple to understand and easy to apply – especially in the field of day trading, which only requires the fundamental tool that technical analysis offers. More importantly, technical analysis does not only relate to dry analysis and comprehension, but actually offers a practical method for stock trading.

Technical Analysis: What Does it Entail?

  • Technical analysis is a review of graphs showing the behavior of a financial product for the purpose of forecasting future price trends 
  • Technical analysis focuses on price: i.e., the outcome of the totality of insights of all factors operating in the market
  • Technical analysis takes no interest in the reasons for any given price

The technical trader’s three basic premises are:

  1. The change in price embodies all market forces. In other words, the stock price expresses everything that can impact the price in terms of economics, psychology, politics, etc.  Therefore, all that is needed is to follow the price, which reflects changes in supply and demand.
  2. Prices move in trends. Trends are cyclical and therefore generally allow for predicting their direction.
  3. History repeats itself. For more than a century, technical analysts have been assisted by graphs plotting stock trends. Accrued information allows identifying recurring behavior patterns. Technical analysts believe that in certain situations the public’s emotional reaction can be expected, and therefore the analysts presume that based on past history, future movements can be predicted.

Here’s the thing: technical analysis alone will lead you to certain failure. Even if you study all the books ever written on the subject and can quote them by heart, even if you were you to write software that operates according to their doctrines, you’d still fail.

At most, 10% of technical analysis components actually work…but not in a vacuum. If you know which of those components to isolate from all available, and how to integrate them with other components unrelated to technical analysis, you have a good chance of succeeding. But remember, the recipe for success merges experience and art.

Fundamental Economic Analysis: What Does it Entail?

A fundamental investor is one who buys a company’s stock in the hope that the main source of price change will be the company’s performance, which covers changes in sales turnover, profitability, demand for the company’s products, management, cash flows and more. The main tools these analysts use are the company’s balance sheet, analysts’ recommendations, information gleaned from the media, and plain old hearsay.

A fundamental analyst is also interested in the economic status and the sector status to which the stock belongs, such as software developers, semiconductors, and the like. Fundamental investors review market interest rates and try to predict their direction and their scope of change. All this data is weighed, and conclusions are reached. 

These are usually long-term investors who do not expect to see their predictions realized in the short term. They therefore keep their positions in the hope of seeing them turn fruitful over the long run.

I use fundamental analysis at the level of media headlines. I don’t believe in this type of analysis, but I do believe that the public, and funds, believe in it. Therefore, I relate to it with due respect and give it some weight in my decision-making processes. For example: let’s say the public believes that the stocks of a certain biotechnology company will strengthen due to a diverse set of components. This is good enough information for me to realize that I need to focus on technical trading opportunities with biotech stocks. In actuality, I'm merging technical analysis with the fundamental economic analysis.

Random Walk

The theory of roaming negates all types of analysis, whether technical or economic. This theory, developed in academia, sees price change as completely random and unpredictable, and that nothing can be learned from the stock’s history towards predicting its future trend. The theory is based on another called “The Efficient Market Hypothesis,” according to which prices embody all information available in the market. There are no expensive or cheap stocks because the market calculates all risks and opportunities as an embodied price. The “Random Walk Hypothesis” claims that because markets are random, one should “walk” through them “randomly” [from this point on], and that the best way to profit from a stock is through a “buy and hold” action.

There is indeed a degree of randomness in the market, but to say that all price trends are random is unthinkable. Random walk theory claims that it is impossible to overcome market indices and that one would be hard-pressed to explain the success of famous investors such as Warren Buffet and Peter Lynch. Their claim, therefore, includes me and my successful trading colleagues. A well-known joke concerning “efficient market” theories charmingly points to its inherent Achilles’ heel:

Two lecturers on economics see a $100 bill lying on the sidewalk. One bends down to pick it up, while the other says, “That’s ridiculous. There’s no way a $100 bill is just lying there. After all, someone else would have picked it up long ago!”

According to the Efficient Market Hypothesis, someone else certainly would have picked it up long ago, but there it is! Keep in mind that at the basis of both random walk and technical analysis theories is the premise that the market manifests all market factors. The difference between these two approaches is that proponents of the random walk see the market as embodying all information at high speed, therefore, no one has any advantage in the market. Meanwhile, technical analysis claims that important information manifests in the market far earlier than is known to the general public.

Gambling, Anyone?

Actually, this is by no means a legitimate a method. Yet, we must discuss it because, unfortunately, it’s the method utilized by the vast majority of people within the stock market who rush to the stock exchange at its peak and flee at its slump. It is the behavioral norm of the public that generally loses money on the stock exchange. It is also sometimes the approach of inexperienced traders who do not operate according to the most basic trading rules, and do not believe in the principles they have set for themselves. Watching such traders from a distance, the observer may think they are real pros, but the dwindling accounts of these traders tells the true story. Even as a novice trader, be a trader, not a gambler. A sheep dressed in wolf's clothing is still a sheep at heart.

 

To learn more about the stock market and to begin your own journey toward financial independence, visit Meir Barak's site Tradenet and check out his book "The Market Whisperer."  

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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