Tradecraft
The Way of the Trader
By Jonathan Hoenig
SmartMoney.com
February 8, 2001
smartmoney.com
FROM earnings estimates to research reports, most investors aren't just informed. They're saturated. There are literally hundreds of columnists, money managers and message-board contributors, all eager to tell you where the market may or may not be headed. And for every bullish voice, there's usually an accompanying bearish one as well. After all, two sides make a market.
But all the Web's information overload encourages most investors to focus on the wrong question — whether to buy, sell or hold a stock. Now, you wouldn't think this would be such a complicated problem. After all, pick a stock and you've got at least even odds that it will appreciate. In fact, you've got better than even odds, since the market has historically demonstrated an upward bias. So then why do so many people lose money buying individual stocks, and lose even more money trading them?
The answer is because trading is a matter of technique, not simple prognostication. What has been missing from this seemingly endless (and often mind-numbing dialog) about the market's next move is frank discussion about the craft of trading.
Most traders and commentators focus on security selection and analysis. There are millions of investors who've been sold on the idea that making money is simply the process of buying "solid, quality companies" and holding onto them for long periods of time. We would like to think that good companies have good stocks, but in reality it's very difficult to demonstrate a direct cause-and-effect relationship between a company's fundamentals and its stock price. No matter how much research we do, the future is by definition, unknowable. The stocks are just going to move as they damn well please.
And that's why the question most traders should focus on isn't what to buy, but how to buy. It doesn't matter if you're trading soybeans or Cisco (CSCO); cultivating a sound technique will have a bigger impact on your bottom line than any stock pick ever could.
Unfortunately, most people want easy answers. They want a stock tip. If your trading technique is limited to asking a friend "what do you think of XYZ?" I suggest you buy a mutual fund and leave trading to those with the patience to learn how it's done. But if you're interested in learning how to trade, that's what you'll get in the coming months from this column.
I begin with cultivating a philosophy that the process of investment is about making money and protecting one's purchasing power against inflation. While that seems almost too obvious to mention, the fact is that many people are drawn to the financial markets for exactly the wrong reason. They want action. They want quick money.
In my experience, those who crave the adrenaline high of a gambling fix would be better served by a trip to the blackjack tables rather than the stock tables. If you must bid on something, hit eBay, not E*trade.
I want to make money. I don't need to buy every bottom or sell every top, nor does my ego need boosting from friends or cheerleaders on financial television. I'm not looking for an adrenaline rush or something to talk about at cocktail parties. The point of this whole exercise is to make money. Everything else is just conversation.
As a trader, I approach all markets with egalitarian indifference. I have no allegiance to any particular asset class or trading style. My faith isn't in stocks, but the bottom line.
The fundamentals are pretty unlikely to justify your purchase of a stock whose price-to-earnings ratio dwarfs your investment time horizon. All you're really doing is waiting for a greater fool to come along.
I won't say that fundamental analysis is completely useless — just darn close. Attempts to justify why a company should trade at 125 times earnings rather than 80 times border on the insane. And if you buy a stock that trades at a mere 80 times earnings (like say, Cisco Systems), don't kid yourself that you're buying a piece of the company's business — i.e., of its fundamentals — since it will take decades before your portion of earnings exceeds what you paid for it. The fundamentals are pretty unlikely to justify your purchase of a stock whose price-to-earnings ratio dwarfs your investment time horizon. All you're really doing is waiting for a greater fool to come along.
So forget the fundamentals and spare me the message-board banter. Let's talk technique and start by understanding what really moves markets — and that is the relationship between price and liquidity.
More than any other factor, what moves XYZ higher is the liquidity situation for the company's shares. Got it? What moves the market — any market — is a disruption in the normal supply-and-demand situation for that particular security. Stocks go up because there is more demand than supply at current prices. End of story.
So I primarily use technical analysis — not because technical analysis is a guarantee of profit, but because nothing is more central to my goal of making money than the price action of a particular security. If you're going to attempt to profit from buying low and selling high, studying the price action itself seems like a logical place to start. I've got better things to do with my time than figure out how many Pampers Wal-Mart (WMT) is going to sell in the fourth quarter. Technical analysis is where the rubber meets the road. In short, a stock is good if I'm long and it's moving higher.
So if the fundamentals are out, what should you watch? What criteria would prompt you to buy a particular security? And once you've decided to buy, when is a good time to get in? And how do you practice sound money-management skills that can protect your downside while participating in the upside? I'll approach these nuts and bolts of making the trade in my next column, one week from today. |
