Wednesday, 17 January, 2007

Short-term trading

Like many (most?) people who know little about the stock market, my investing is limited to mutual funds and a "buy and hold" strategy that involves dividend-paying stocks in large companies.  Also like many people, I've made some forays into trying to make money fast by buying a fast-rising stock or gambling on an exciting startup.  As you might expect, I had some wins and took some lumps.  I'm a fast learner, though, and decided early on that I shouldn't be throwing my money at something I didn't understand.  Trying to make money trading stocks when you don't understand what's going on is just gambling.  Stupid.

I've done okay with my investments over the years.  Not setting the world on fire by any means, but I have more now than when I started and it doesn't take me a whole lot of time to review my holdings periodically and readjust when appropriate.  I've also nurtured a healthy distrust--one might say unreasonable fear--of "trading," to the point of being convinced that it is nothing more than gambling.  I've recently had occasion to rethink that opinion, so I thought I'd take a closer look at it.

Understand up front:  nothing in the discussion below is intended as encouragement.  You will never see me recommend that somebody take up short term trading in the stock market.  At this point in my research I'm not even sure that I'll attempt it.  I'm just interested in learning more about how it works.  If it works.

A "buy and hold" investor purchases shares of a company's stock based on the company's long-term growth prospects.  They expect the company's value to increase and the stock price to increase along with it.  In addition, the stockholders participate in the company's profits through quarterly dividends.  This kind of investing is seen by many as the "right" way to do it.  If you do your research, buy stock in a quality company at a good value and hold it for a long period (years), you can do very well.  Warren Buffet has proven that spectacularly, and others have to a lesser degree.

Traders are completely different.  They attempt to make money by taking advantage of volatility in the market.  The money they make comes not from the companies whose stock they buy, but rather from other traders who lose money.  Or from ordinary people (like me) who make stupid gambles and lose.  The basic tool of the trader is called technical analysis, which has received a bad rap over the years.  That bad rap is, I think, mostly undeserved.

Technical analysis is based on the observation that in the short term stock prices move in indetifiable patterns that are based mostly on the emotions of greed and fear.  The long-term prospects of a company do come into play, but act mostly as motivators for one of those two emotions.  For example, a rumor might surface that Jim's Unique Kryptonite (JUNK) will announce a new product.  Greedy investors jump into the stock, hoping that the new product will increase the company's revenues.  More demand drives up the price and more buyers jump onto the bandwagon.  At some point potential buyers see the price as too high or traders decide to take profits, and the trend reverses:  people begin selling the stock, the price begins to drop, and more holders begin to sell because they fear the price will drop below what they bought it at.

That's oversimplified, of course, but it's essentially how stock prices fluctuate over the short term:  greed drives prices up and fear pushes prices down.  In extreme cases you'll see things like the late 90s tech stock boom, where prices went rocketing up beyond all reason, only to come crashing down even faster when people finally realized that they were holding $2 worth of stuff that they paid $10 for.  But even in a relatively stagnant market, prices will often fluctuate ten percent or more over a relatively short period.  Short-term traders attempt to take advantage of and make money from those fluctuations.

Make no mistake, short-term trading is a competition.  Not every dollar made by short-term traders is offset by somebody else's loss (share prices do tend to rise in the long term), but one could safely say that most of the profits are gained at somebody else's expense.  If you understand that, then you're one step ahead of many others.  Those who continually come out on top in any competition do it through hard work, not luck.

Technical analysis is how traders refer to the wide range of analysis tools that they use to predict the movements of stock prices.  Analysts look at things like volume, moving averages, candlestick charts, oscillators, and untold others to spot trends and, more importantly, impending trend reversals.  Their intent is to catch a stock just as its price begins to move up, and then to sell it just as the price begins to move down.  Or, in reverse, sell a stock short just as the price begins to decline, and then buy it back (cover the short) just before the price begins to rise again.  The time period involved is usually three days to six weeks.  Day traders have a much shorter time scale (minutes to hours) and use some different indicators, but they work in essentially the same way.

My question, when I began researching this, is whether or not there is actually some validity to all those numbers, charts, averages, trend lines, and so on.  What I've discovered so far is that there does appear to be something there, although like anything it's not as simple as it first seems.  Stock prices do move in recognizable patterns over the short term, and it's possible to predict those patterns with some degree of accuracy.  Sometimes.  No trader is always right.  In fact, some successful traders are wrong more often than they're right, but with tight money management they're able to minimize their losses, maximize their gains, and still come out ahead.

Based on everything I've read so far, I'd say that it is possible to make money by short-term trading.  It's not easy.  It requires patience and study as well as discipline.  A lot of discipline.  And that's where I think most of the amateurs go wrong.  They don't have the patience to really study and understand what they're doing, and they lack the discipline to develop and implement a coherent and workable plan.  Without those things, a trader is only a gambler, and he's playing a game that he can't win against people who are very motivated and quite serious.  He can only get lucky once in a while.

The "bad rap" that technical analysis has received appears to be the result of people who dabbled in it without understanding what they were doing.  Typically unwilling to accept the blame for losing their money, these people instead try to offload the responsibility.  "I tried that technical analysis crap.  I lost all my money."  Funny thing is that they credit their own genius for their gains.

As it stands, there's no way I would attempt a foray into short-term trading with the little knowledge that I currently possess.  There are way too many things that I don't understand.  I'll continue to research it because I find the subject quite interesting, but right now I can't say that I'll ever study it in depth and follow closely enough to feel comfortable with attempting it.