Discussion 7 : The Psychologist in Stocktrading

I remembered I attended an interview for the position of Internal Auditor (IA) long ago with a company located somewhere in Bayan Lepas. It was a company operating in the trading of consumer goods such as liquor and tobacco in duty free zones, and has many outlets all over Malaysia.

In the second interview, it was the Director of Audit and Risk Assessment who conducted the interview for me. While I don't really recall the exact lines we exchanged during the interview, I remembered these were about the few lines that took place during that event:

"Why bother yourself to study Certified Fraud Examiner (CFE)? How does it add value to being an IA?"
"CFE allows me to detect and prevent a fraud from taking place."
"How so?"
"We can technically see vulnerable openings in an internal control (IC) system and can also read the probability of the entrusted personnel of committing fraud under such environment. In CFE, we learn a small degree of criminal psychology to help us determine so."
"You can't do that! You can't rely on psychology to detect fraud! Psychology is no evidence!"

Well, he has already gone all defensive. >.<

The reason I shared this with my readers is to show that people might behave ignorantly when they are persuaded to comprehend something that differs from their ideas, or the norms. People naturally don't like those who are different from themselves. So, it is perfectly normal for a typically average person such as that director who interviewed me, to react in such passion.

Honestly, I don't mind, because I believe that when great peoples see quality, their minds concur each other almost instantly. :-)

In stocktrading and investment, the philosophy is the same, and candlesticks in essence, is CFE to an IA.

Candlesticks act as a tool to recognize an opening in the stock prices for good entries (as in detecting openings in IC system) and to read the psychological behaviour of investors towards the stock (as in determining the probability of a potential fraudster to commit fraud). Literally, they are your little psychologists in stocktrading and investments.


In Discussion 4 (Part 2), I have introduced to my readers two sets of candlestick patterns that are useful to recognize trend reversals. Those are the Hammer and Engulfing sets, which consist of :-

1. Hammer
2. Inverted Hammer
3. Shooting Star
4. Hanging Man
5. Bullish Engulfing
6. Bearish Engulfing

Please ensure that you know these candlestick patterns prior to continuing with this Discussion. I will now proceed with candlesticks in the next few Discussions to further fortify your understandings on this subject.


THE PSYCHOLOGICAL MAGIC OF CANDLESTICKS

Firstly, having known how to use the candlesticks, have you ever asked yourself what is the logic behind candlestick patterns? If you had, please recall your answers now. If you have not, then start thinking now, before going on to the next paragraph.

Consider this situation in a downtrend:

1st Session (9.00am to 12.30pm) = Stock opens at RM10.00, closes at RM5.00
2nd Session (2.30pm to 5.00pm) = Stock opens at RM5.00, closes at RM12.00

How would both candlesticks look like?


Illustration (i) : Hammer Formation

In the 1st session of trading, you would be able to see that a black candle is formed. In the 2nd session, a white candle. Now, how would the candlestick look like for the entire day? See illustration (i).

Now, do you understand how a Hammer is formed? During the morning, bears clawed the stock downwards by 50% (Note: For illustration purposes only. In reality, it won't be that drastic!). However, after noon, the bulls made a comeback to thrust the price to close higher than today's opening. At the end of the day, bull wins.

This shows that in investors' psychology, the stock's value should not be any lower than RM5.00 (which means, RM5.00 is the support). When the sellers (panic-struck Dumb Money) put the stocks up for a big cheap sale, buyers (Big Money and Smart Money) retaliate instinctively and begin buying (accumulating) the lovely RM5.00 pizza at a low.

Due to the subsequent increase in demand for this stock, the price would then begin to soar higher and higher, making subsequent higher lows and higher highs. The once price downtrend has now turned into an uptrend.


[Terminologies
Smart Money usually refers to Sophisticated Investors (SI) who possess a lot of funds, have many years of investing experiences and practices highly complex investment strategies.

Big Money refers to investment professionals such as Fund Managers, etc...

Dumb Money are retail investors like you and me. In U.S., we are more commonly known as "The Suckers" *sob*]


Now, consider this situation in a downtrend.

1st session = Stock opens at RM5.00, closes at RM10.00
2nd session = Stock opens at RM10.00, closes at RM6.00


Illustration (ii) : Inverted Hammer Formation

The Inverted Hammer is then formed. The bulls retaliate to a downtrend by pushing the stock price to a day high, but then are eventually suppressed by the bears. Even though the rebel failed on this day, the message of revolting against the bears is clearly seen. The days of the bears' glory are numbered.

As the panic-driven Dumb Money made their exits at lows in distress, huge amount of Smart and Big (S&B) Money flow into this stock and send the stock price rocketing towards the moon.

However, when these are formed on top of an uptrend, a Hanging Man shares the same psychology as Inverted Hammer, while Shooting Star shares the same psychology as Hammer.


Illustration (iii) : Hanging Man Formation

The S&B Money would first send the price to an uptrend. When the Dumb Money finally realizes the train is moving up, out of greed, they quickly jump aboard the train, regardless of the ticket price! Once the S&B Money sees the euphoria, they evilly sell their stocks at a high (distribution) to the Dumb Money. As the Dumb Money buys the stock, they don't realise that they are paying a high price for a downwards heading train! This is how the S&B Money 'sucker' the Dumb Money. :'-(


Illustration (iv) : Shooting Star Formation

In the Hammer set and its variation set, the candlestick body's colour isn't important. The whole idea of the candlestick pattern is to show us that the S&B Money has taken noticeable moves to 'overthrow' the current trend. This is when we should be prepared for a potential trend reversal.


As a distinguished investor/trader, these candlesticks play an integral role in determining the S&B Money's directions. We would want to hitch a ride with the S&B Money, rather than with the Dumb Money, aren't we?

Monitoring the candlesticks enable us to understand the psychology of investors, which in turn allows us to make informed decisions on when the trend is likely to make a reversal, and most importantly, allows us to time a trend ride with the force (S&B Money).

So, those who remain not agreeing that investors' psychology is useful, or still thinks that psychology is not evident and therefore can't prove much, you may stay on as a 'sucker' for all I care. For those who agree, welcome aboard the S&B train! It'll be a much more comfortable ride. :p

Open up your minds now. There are a lot more to come.


[P/S: Will you be able to figure out the psychology of the Engulfing set on your own? Please try so before Discussion 9. Put on your thinking cap! :-) ]