Every puzzle comes in a box, which has the picture of how it’s supposed to look printed on it. It’s not a manual on how to assemble, it’s rather a snapshot of how the end result will look. Thus, over the first series of guides, you’ll get a preview of how this complete picture should look, a ‘high-altitude’ overview of how speculating in stocks works as a unit over a market cycle. Do not try to remember every detail, and don’t try to abstract what to do in each context. This is merely so you can get a larger picture of the puzzle, so that it will be easier to pluck together the smaller pieces that we’ll later look at in detail, one by one.
The need for a strategy
To thrive for years and decades consistently in the stock market, to not become a one-hit wonder in a big bull market who then proceeds to give back all his profits at the end of the cycle, and to not get married to your pet darling stocks and expect them to out-perform every cycle over and over, you have to understand how the stock market clockwork operates. You have to understand the natural forces that drive it.
The market is a simple system that a whole industry is trying to sell you as something so complicated that you need financial advisors with fancy degrees to give your money to and make decisions for you, for a modest fee of course. And if it goes against them and they lose your money … well, they’ll just point to the small print that you signed in the beginning, pontificating that “the stock market carries inherent risky and you might lose all your capital”. Making money in such a way doesn’t sound like a plan, but a hope.
It’s up to you to turn the tables and learn how to make money in the markets. There are literally hundreds of ways – strategies – to do this. And each assumes a slightly different perspective and requires understanding of the market from a slightly different angle.
There are good strategies, bad strategies, and no strategies. But the main key is consistency in application – a bad strategy well applied will make equal profits to a great strategy badly applied. This consistency is based in the psychological conditioning of the person acting in the market, something we will look at later in this course. For now, it will suffice to state that anybody in the markets who makes profits consistently over a long time frame, is using some sort of a strategy consistently.
There is no silver bullet
The first thing to learn is that there is no strategy that works all the time. As the market moves in cycles, different strategies start working better or worse at different times, as they flourish in different market environments.
It’s critical to grasp that what makes a strategy great is that 1) the strategy works phenomenally at some times, and 2) it does not lose significant (or any) money the rest of the time. There are many strategies that work well at some point in the cycle … but if you continue to use them in another part of the cycle, or have no method of telling when you shouldn’t use it, and you will lose your shirt. At the end of the day, while winning sometimes means making big profits, at other times it simply means ‘not losing’.
The question arises “Why don’t strategies work all the time?” A sound strategy produces profits by finding a temporary disturbance between market forces, a disequilibrium of buyers and sellers. Such a disturbance, also known as market inefficiency, will prompt market participants, who now see an opportunity to exploit for profit, to act. Their actions generate (sometimes more or less) predictable movements of the market back towards equilibrium, movements that can be capitalized on.
By their nature, these inefficiencies are tied to certain environments, and thus windows of time in the market cycle that can be as short as minutes or as long as years. In the end, each existing strategy exploits different inefficiencies that tend to appear more often in certain parts of the market cycle than in others, thus strategies will at times work better or worse, depending on one’s position in the market cycle.
Different strokes for different folks
All participants are in the market for their own benefit, and try to do so with varying strategies they find optimal or that fit their character. There are literally hundreds of ways to skin the cat, many of which are hybrids of multiple others.
For example, there are ‘value investors’ who try to fish for and buy price bottoms in certain stocks that fluctuate with the business cycle every couple of years. There are traders that specialize in arbitration between different marketplaces and exchanges. There are quant shops using algorithms, there is high-frequency trading, there are top-down shops running long-term macro portfolios. There are income and dividend strategies, there is passive “investing” via ETFs (also just speculation), there is inflation hedging. There are fundamental short sellers and there are technical short sellers. There are options and futures traders. There are scalpers and daytraders that sweat to make hundreds of trades per month accrueing many small profits. There are swing-traders that trade the daily and weekly fluctuations, there are multi-month- or year position speculators and multi-decade long-term speculators, the latter who call themselves “long-term investors”. Of course, there are also as many mixed strategies as there are grains of sand on the beach. The list goes on, and you get the gist.
People acting in opposite directions can both be right
Everybody in the markets is out to make a profit, and many of their strategies are diametrically opposed to each other – still, all of them can be profitable.
For that to be possible, it means that profiting is less about the exact strategy employed, and more about diligent application of common underlying principles. To be successful, it is paramount to focus on a single strategy, to become the best at it. It takes long enough to master one craft – and as in any discipline that requires skill at high levels, generalists have no place in the market. Trying to be a jack of all trades will end you up master of none. Although sometimes helpful for a narrative understanding of market dynamics, knowing how all of those strategies work that are described above is not necessary for you to be profitable.
The sum of people’s actions determines stock and market trends
How do we see through these hundreds of different types of people operating in the markets in their own little spheres, doing their own thing? Well, when taking a step back, all anyone can really do in the market is buy, sell or hold – and thus, the only thing that really matters is a composite picture of this buying, selling and holding added up, which leads you to the domain of supply and demand.
And the markets work in the way that when the sum of buying demand, for whatever reason it appears, outpaces selling pressure/supply, prices move up. When there is few sellers and eager buyers willing to pay premium for a stock, sellers become picky and only sell at a premium, pressing prices up.
The opposite is true for the sum of selling pressure outpacing buying demand. Prices sink when many sellers that want to urgently sell make concessions on what price they can sell at, and the few buyers willing to scoop up the stock are only willing to do so at lower price for a perceived ‘bargain’.
Again, the reasons for the buying and selling don’t really matter in the end – but the total sum of it and which way the scale tips, does.
The formation of trends
If these changes in demand and supply happens for a sustained amount of time, prices will form a trend, up or down, at different intensity, for various duration. Trends will be very important for us later on. From whatever perspective you look, the market works in trends spanning seconds, minutes, hours, days, weeks, months, years or decades. And these are driven by imbalances in buying and selling i.e. supply and demand.
Now, the average price movement of all stocks are mirrored approximately in the price movements of market averages such as the S&P 500, the NYSE Composite or the NASDAQ Composite. These are what many people refer to when they talk about “the stock market” – but in reality, as we will see later, they are only a tiny fraction of what really matters and makes up the stock market.
You’ll see that stock indices move in a series of waves, or trends, which are nested within a larger overall trend, and they are all interrupted by breaks (“Corrections”) and turning points in between. This goes for both up- and down-trending markets.
This is not only true for averages, but also the individual stocks that make up the stock market. Don’t let the detail confuse you – for the moment it’s sufficient to know that there are trends and that the averages tend move in them a lot of the time.
Of course, the stock market is very diverse, and contains anything from slow sluggish stocks to very fast movers. Keep in mind that when the market averages trend up, there are always many stocks that wildly out-perform them on the upside, while many other stocks move much slower.
That is because there really is no such thing as a “stock market”, only a “market of stocks”. That means, such stock averages, or indices, can give us a helpful insight to some degree, but on the other hand cannot really show us the final picture of what happens with all the constituents of said averages.
At this point, as have many “smaller” successful market operators before me (“small” being anyone working with less than a few hundred million dollar in their accounts), I have recognized that the big money is not made by trying to catch the bottoms, or selling tops, or in trading a million times on the small wiggles in between.
Rather, it is made by catching and riding the middle, meaty part of a strong trend in the general market averages by being in the stocks that amplify that trend the most.
This encompasses first having a method to pinpoint a long-term trend in the general market right around when it starts, and then by finding and latching our money on to the stocks that outperform other stocks and the indices the most, and move the furthest.
