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Are You Trading Stocks, or Are You Trading Emotions? 


Most market participants like to believe that the process of investing and trading is based on valuations, mathematics, potential growth, interest rates, and a host of other hard facts that move stocks and the stock market. All of these things do matter at times, but in the short term, it is all about emotions. What most traders are really doing is navigating the emotions of other traders.

The specific details of a stock don’t matter much in the very short term. Fundamentals or news flow may trigger a move in a stock initially, but then the emotions take hold as the price action shifts, and that is what we really are navigating after a certain point. If we want to navigate the action effectively, we have to start operating as psychologists rather than stock analysts at certain times.

Many traders have a hard time making this sort of shift. They want to believe that the price of a stock is anchored to fundamentals in some way. There is a tendency to view emotional reactions as irrational, and rather than embrace those moves, we look for justifications that are really irrelevant to the situation.

As I write this, I’m watching the trading in a stock called Support.com (SPRT) . SPRT has been volatile for a few weeks now and has been in a great trading environment, but Friday morning it was trading up $28 or 140% on no new news. It is pure emotion driving this stock right now, and all we can do at this point is trade the emotions that are driving it and forget about what the business might be.

Similar action occurred in ‘meme’ names like GameStop (GME) and AMC Entertainment (AMC) . Those trades basically started as pure short squeezes, but over time the ‘diamond hands’ holders started coming up with a fundamental argument to justify the action. They didn’t want to admit that the trading was emotional and irrational.

To some extent, very short-term trading is like a Ponzi Scheme. Ponzi Schemes are illegal. They are a form of fraud that involves paying a return to an early investor by using funds from later investors and creating the illusion of a booming business. The key to a successful Ponzi scheme is an endless supply of new buyers. As long as there are more buyers, then the early buyers are safe and can generate tremendous profits even if the business is a scam.

All very short-term trading has a similar element. The main reason that traders will chase some worthless meme stock is because they are convinced that there will be another buyer in the future that will pay more. Whether there is a worthwhile business enterprise with intrinsic value simply doesn’t matter much in the short term.

Typically when a trader finds that their timing was bad and they paid too much, they will start to look at ‘value’ and try to find justifications for why the stock won’t totally collapse.

Much of the social media promotion of certain stocks is tantamount to a Ponzi Scheme, but there is almost always some sort of valuation argument that can be used for promotion. The other alternative is to embrace the fact that the stock is worthless, but there are short-sellers that are betting on that fact, and they can be squeezed to ridiculous levels before they will finally give up. They may be right, but many short sellers have learned that they can’t stand up to thousands of traders that push a stock higher on a daily basis.

It is fascinating when you consider the psychological element of trading independently of the fundamental factors. The two things always entwine to some degree, but there is a constant shifting during the trading process between emotions and fundamentals.

It can greatly improve your trading when you start seeing the emotional aspect of trade as separate and distinct from the fundos. The best trades come when you can align the two issues and see clearly how the fundamental characteristics are driving the emotional aspects.

The best traders tend to be psychologists rather than mathematicians, but a combination of the two is the ultimate goal.

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