The Psychological Side of the Trade
We live in a speculative financial world. In an ideal, basic economic society, you could imagine how goods and services would be exchanged in a matter-of-fact and straightforward way: A farmer tells a hunter, "It took me two days to produce 30 gallons of milk, and it took you two days to deliver a butchered deer, so let's make an even trade." In modern times, though, the value of goods and services are based to a significant extent on opinions, rather than on an objective, tangible value. We frequently buy houses that are overvalued based on the assumption that they will increase in value. We pay more for special edition cars not because they are faster than a standard model, but for their rarity, and the feeling of uniqueness they offer. And when it comes to trading the markets, we invest in stocks that are much higher than what a fundamentalist would pay based on dividends. It is the speculative nature of trading that makes it inherently psychological. We try our best to id entify trends and price ranges, but in the end, they are merely educated guesses. There are numerous unknown factors that influence stock prices and we can do nothing more than accept this uncertainty, and try our best to make a profit.
In principle, trading is straightforward. You pick a stock that will go up, buy low and sell high. Or go short by buying to cover and selling when the price goes down. If stocks went up and down as reliably as ocean tides, you could profit easily. Unfortunately, the ups and the downs of the markets are not always predictable. Indeed, if the market were that reliable, traders could not make money. If everyone knew the high and low points, traders could not profit by selling stocks to unsuspecting buyers at high prices, and buying them back when the price falls hard and the masses sell out of fear.
The challenge in trading is handling the psychological uncertainty. In the end, you must take a risk and decide where the price of a stock will go next. For example, consider a stock that has a clearly defined price range. Suppose that the stock traded between $50 and $52 for the past five years, and suppose there was clearly defined support areas at $50 and the price could not break through the resistance level of $52. But what happens when the price reaches $54 and has high volume? Where do you think it will go next? Will it move higher than $54? Will $52 be the new support area, or will the stock go down to the support area of $50? This is where you must make an educated guess. You must carefully review all available information and decide where new support and resistance levels will fall.
We frequently must make decisions where we are required to guess what will happen next, but the markets are often fickle. We must beat out other market participants and sell them stocks that are at a high point, and buy stocks from them that are at a low point. It's a matter of psychology. What do they think and what do you think? The one who is right is the one who wins.
