Do you trade stocks or trade emotions?

Most market participants like to believe that the process of investing and trading is based on valuations, math, potential growth, interest rates, and a host of other hard facts that move stocks and the stock market. All of these things matter sometimes, but in the short term it’s all about emotions. What most traders really do is navigate through the emotions of other traders.

The specific details of a stock don’t matter much in the very short term. Fundamentals of news flow may initially trigger a move in a stock, but then the emotions get the better of them as the price action shifts, which is what we really navigate after a certain point. If we want to navigate the action effectively, we need to start operating as psychologists rather than stock analysts at certain times.

Many traders have a hard time making these kinds of shifts. They want to believe that a stock’s price is somehow anchored to fundamentals. There is a tendency to view emotional responses as irrational, and instead of embracing those moves, we look for justifications that are really irrelevant to the situation.

As I write this I am looking at trading a stock called Support.com (SPRT). SPRT has been volatile for a few weeks now and has been in a great trading environment, but on Friday morning it was trading up $28 or 140% with no new news. It’s pure emotion that’s driving this stock right now, and all we can do right now is trade the emotions that drive it and forget what the company could be.

Similar action took place in “meme” names like GameStop (GME) and AMC Entertainment (AMC). Those trades actually started out as pure short squeezes, but over time, the diamond hands holders came up with a fundamental argument to justify the action. They would not admit that the trade was emotional and irrational.

To some extent, very short-term trading is similar to a Ponzi scheme. Ponzi schemes are illegal. It is a form of fraud where an early investor pays a fee by using money from later investors and creating the illusion of a thriving business. The key to a successful Ponzi scheme is an endless supply of new buyers. As long as there are more buyers, the early buyers are safe and can generate huge profits even if the company is a scam.

All very short term trading has a similar element. The main reason traders hunt for crappy meme stocks is because they are convinced that in the future there will be another buyer who will pay more. Whether it is a valuable company with intrinsic value does not matter much in the short term.

When a trader discovers that his timing was bad and he has overpaid, he will usually look at “value” and try to find justifications as to why the stock will not completely collapse.

Much of the social media promotion of certain stocks comes down to a Ponzi scheme, but there is almost always some sort of valuation argument that can be used for promotion. The other alternative is to embrace the fact that the stock is worthless, but there are shortsellers who bet on that fact, and they can be squeezed to ridiculous levels before eventually giving up. They may be right, but many shortsellers have learned that they cannot withstand thousands of traders pushing a stock higher on a daily basis.

It’s fascinating when you look at the psychological element of trading, independent of the fundamental factors. The two things are always intertwined to some degree, but there is a constant shift during the trading process between emotions and fundamentals.

It can greatly improve your trading when you begin to see the emotional aspect of trading separate and distinct from the fundos. The best trades come when you can align the two issues and see clearly how the fundamentals drive the emotional aspects.

The best traders are psychologists rather than mathematicians, but a combination of both is the ultimate goal.

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