The price of a financial instrument (stock, future, option etc..) is the most critical factor of consideration for all investors, regardless of their investment style, when deciding what and when to buy or sell. The current price determines whether a trader will enter a long position, believing that price will increase in the future, or enter a short position, believing that prices will fall. Although given the critical importance of price, there is an all too common misconception many traders have about it, and that is the belief that at times the current price is wrong. In certain situations, some traders believe that after the price of a financial instrument has moved far and fast in one direction, that it has reached an incorrect level, and thus invariably must return to its previous range. Often they come to this conclusion not through logical, proven, and well thought-out analysis techniques, but based on purely emotional reactions. These traders will then enter positions with the belief that price has to return to levels which they are more used to and comfortable with. However, this way of looking at the price level is fundamentally flawed because when one truly comes to understand what drives price movements as well as what price reflects, they will realize that price can never be wrong.
Investors most commonly come to the the belief that price is wrong when it has moved either far to the upside, or far to the downside, in a short period of time. Even more frequently, this belief of wrong prices occurs when price reaches unseen levels in relation to what history has seen. A recent occurrence which saw the aforementioned trading behavior take place was during the dramatic move of oil prices in 2008 (for a price chart click here). Early in 2008 oil prices increased to new highs, breaking the coveted $100 dollar level for the first time and leading many investors, media talking heads, and self-anointed experts, to announce that these prices couldn't be sustained and now was the time to sell any existing long positions or even worse short oil futures. However, as we all know this was certainly not the end of oil's bullish move as prices increased almost another 50%, peaking at $147.30 in July of 2008. If one had traded based on the assumption that price at $100 was wrong then they would have missed out on a lot more profit potential (if they were already long), or if they had shorted oil futures as many investors did, they would have likely sustained substantial losses (assuming that they did not have huge amounts of spare capital to fulfill margin calls, and extremely strong conviction to watch the dramatic increase in oil price unfold). While the price of oil did quickly fall off its summer high, the same irrational beliefs and trading practices occurred on the way down. In the fall of 2008, oil moved back to around $80 a barrel, and at this level many of the same people who thought it was a sell at $100, now believed that this dramatic decrease presented an excellent buying opportunity. Again without analyzing the price changes in logical and proven methods, they believed that price was again wrong and it would soon move back towards the $100 level, possibly even eclipsing its high. But by late 2008 oil had moved sharply from the $80 level, decreasing to below $40 a barrel, which resulted in huge losses for those who bought at around $80 a barrel.
If ones steps back and analyzes this trading phenomenon it is easy to see why it happens, irrespective of the fact that it is not a logical or sustainable trading strategy. The primary cause of this behavior among market participants results from the fact that many investors make trading decisions based on emotions. When prices move quickly and significantly either up or down it greatly plays on the joys and fears of traders. Seeing prices at new, and in some cases never before considered possible levels, moves many investors out of their emotional comfort zones, causing them to make irrational decisions. Often these new prices (such as oil prices in 2008) are so far from what most have become comfortable with, that many traders automatically or possibly even unconsciously, convince themselves that the prices are wrong and will soon return to the levels with which they have become accustomed to and believe to be "right", and thus think that they must take advantage of these prices while they can. To make matters worse the speed at which prices often arrive at the new levels cause many to quickly enter trades with hope and emotion overriding clear analysis and good judgment. However, at times like these it is crucial for investors to step back and use the proven trading methods they have developed to see if they can discern with a high probability where price will go next, without letting emotions cloud their judgment. If traders continue to trade based on these harmful emotions which cause them to believe that prices are at "incorrect" levels, they will quickly run out of trading capital, as ultimately the price of any freely traded financial instrument can never be wrong.
To further grasp why price cannot be wrong, and why trades should never be made based on this premise, it is crucial to understand exactly what price means and what it reflects. The price of a stock, future, exchange-traded fund, or any other freely traded good for that matter, is determined by the interaction between supply and demand. Supply of an equity will rise when the number of people who wish to sell their contracts increases, while demand rises when the number of people who want to buy contracts increases. When demand increases faster then supply, price will rise, while when supply outpaces demand, price will fall. Investors normally make the decision to purchase an equity (increasing demand), when they have a piece of information which they believe will result in a rise in the future price level. Conversely, one decides to sell an equity (increasing supply), because they obtain information which they believe will lead to a fall in price. So all these bits of information, whether they are correct, well thought-out, or even logical, determine supply and demand, and reflect the collective psychology that all market participants have towards a financial instrument. When price is understood to be resulting from the collective impact of the overall psychology of all market participants on supply and demand, one can see that logically price is never wrong, as for each and every moment that trading takes place, price is at the only level which matches the demand of the buyers with the supply of sellers.
To conclude, most investors actually see some of their greatest returns when prices reach new levels, as these are often the times which see huge price moves and also when the general market consensus is confused and reacting emotionally. Traders who use logical and well tested methods of analyzing trading psychology which are not influenced by their emotions, but instead on criteria which they have proven increases the probability of entering a successful trade, can often take advantage of these large moves. So in order to be a successful and profitable investor one cannot look at current price in a manner of being right or wrong, too high or too low, but instead must pay attention to trader psychology and look to find reasons why the psychology could change and what effect these changes will have on the supply and demand of the financial instrument under study.
Posts
