Lessons from the Pros

Futures

Is Too Much Bullishness Good for this Rally?

Two of the oldest and most commonly used terms in the stock market are Bulls and Bears.  These two references are used to describe an investor’s outlook on the market. If an investor is bullish, he is positive on the prospects of the Stock Market going higher.  With human nature being what it is, sometimes those already invested in the market persist with a bullish outlook in spite of bear market warning signs. In psychology, this phenomenon is referred to as confirmation bias which is defined as a state where humans tend to rationalize their decisions and dismiss or entirely ignore any data that doesn’t validate their point of view.

Newspaper headline clippings about record high stock markets.

Contrasting the bulls are the bearish cohort of the market. These market participants are less sanguine on the market. In fact, they’re opinion on stocks is downright gloomy. Their confirmation bias causes them to actively look for and rationalize every reason why stocks will decline. They likely already own put options, are short sellers, have already sold all of their stock or are looking to profit from a lower market in some fashion.

With this in mind, let’s delve into the mechanics of the market.  Any free market needs to have buyers (Bulls) and sellers (Bears) in order to have movement and, because all market participants have a different perception on what constitutes value, both buyers and sellers are ever present. For trading transactions to happen, buyers and sellers have to come together.  A buyer will take a trade in the hopes that he will sell his shares at higher prices. He believes that at current prices the stock offers value. This buyer has to find a seller in order to complete his transaction. The seller, on the other hand, has an antithetical view and believes the stock is overvalued or least fairly valued and, therefore, wants to sell.

Another major factor in price movement is the number of unfilled buy orders (demand) and unfilled sell orders (supply) in the market. At the price point where the unfilled sell orders surpass the buy orders by a larger margin, price will likely stop rallying and turn down. This is because buy and sell orders have to be matched, as mentioned earlier. The same applies to buy imbalances, just in reverse. This is the point where price will likely stop falling and rally.

This brings us to the question of whether too much bullishness is good to sustain a rally. Our current stock market has had a terrific rally and Wall Street is very bullish now. They’re touting how great the economy is doing and how so many companies have been reporting earnings that have exceeded analyst’s expectations.

On the surface, this seems very positive, but if we think about the dynamics that we covered earlier, what’s happened so far? The first question to ask is, are the majority of market participants long (already owning the stock)?  If this is the case, are these investors now supply or demand going forward? The answer is they are now supply because, in order for someone who owns stock to realize a profit, they have to sell. They need to find a buyer to take their stock. However, if buyers are no longer as eager to buy, then price will have to fall. How far? To a price point where potential buyers find value again.

Do you ever wonder why high flying stocks or futures contracts fall precipitously after a very strong rally? That is the supply and demand dynamic at work.  Those that hold the stock want to believe that price can just keep going higher but eventually, when price gets so high no one is willing to buy or so low that no one is willing to sell, the law of supply and demand takes over. As traders and investors, we have to guard against trading based on emotion and instead trade based on what the charts are telling us. So, the answer to the question is, too much bullishness is not good for a rally because as prices rise less and less people are willing to buy until, finally, price has to start dropping.

The point here is to give an understanding of the real dynamics of the market place so you can avoid succumbing  to conventional thinking. The reality is that most traders and investors don’t do well in the markets. They let their emotions take hold and buy when everyone is bullish (usually near market highs) and sell when the markets are perceived very bearish (near market lows).

So next time you’re about to buy a stock or go long a stock index futures contract, it would serve you well to ask: who’s going to sell to me? If the answer is an institution, you’re probably on the wrong side of that trade. If, however, a retail trader is taking your trade, your odds just increased dramatically that you’re on the right side of the market.

Of course, we can’t actually see who we’re trading against, but certain price patterns will help us in making an educated guess. Learning these patterns could help us trade with less risk and higher probability. If you’re interested in learning a different way of viewing the markets, contact one of the many OTA centers for a free seminar.

Until next time, I hope everyone has a great week.


DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.