What Can Traders Learn From Investors?

Earnings Still Mean Everything

If sound trading strategy can be boiled down to just one key idea, it's this: You want to move before the rest of the market does. Sounds too simple, doesn't it? However, no matter what technique a trader is using, all he or she is really trying to do is find current opportunities that nobody else has found yet. Later, when others realize the same value, their buying efforts will push stocks higher or lower, as the case may be. There are certainly many techniques to find those opportunities, but they're all ultimately designed to beat the crowd.

The goal for traders is to deduce what investors are likely to do to a stock over a particular time frame - usually a short time frame. Now ask yourself, what single piece of data is most scrutinized by the investing crowd? The answer: earnings . The only compelling reason anybody would want to own shares in a company for the long haul is that the company has at least the potential earnings of similar investment options. If a company can't provide adequate compensation for the risk that investors must take on, investors have no real reason to continue holding that stock. If a company can provide risk-commensurate returns, investors will be scrambling for its stock. The problem is that investors can't do all this buying and selling in a very orderly fashion. In fact, the market can get downright disorderly when investors get too emotional about earnings (future or present). When the investing public makes a mistake and provides the trader with an opportunity to take advantage of the likely correction , this is the so-called "sweet spot" for traders.

As a trader, keeping tabs on earnings could provide an edge when it comes to being able to answer two key questions about a company: First, is the company profitable, and what kind of earnings growth are they achieving? Second, and perhaps most important, what kind of response will any earnings news create? It pays to find out whether the company has a history of over-promising and under-delivering as well as how investors typically behave before, during and after earnings news. Also keep in mind that individual stocks have 'groupies' that create reasonably predictable movement patterns around earnings.

Hype Can Defy The Odds

As any trader will tell you, trading is a game of odds, not a game of logic. That's why most traders use some sort of data-oriented or charting software. These programs help traders weigh the odds that a particular event will actually happen. In fact, the more mechanical the trading system, the more effective it usually is.

However, there is a flaw in the methodology. The odds that a trader seeks to define are largely based on history. For instance, a chart-watching technician is looking for particular historical patterns that have repeatedly led to the same result. When that same pattern is seen again in the future, the trader will act on the assumption that the same result will yet again be achieved. This gives the trader an idea of his or her odds for success on a given trade.

The flaw in the trading strategy becomes evident when things go awry. Take the year 1999, for instance. In that particular year, most traders were seeing all sorts of overbought chart patterns - a condition that indicates stocks have moved too high too quickly and are likely to pull back. Despite these signals, stocks didn't pull back until early 2000. Had a trader acted on those bearish signals, he or she would have been well into the red that year.

How can a methodology that works so well in most cases end up working so poorly in others? In many cases, hype and hysteria can overcome odds and tendencies and the historical patterns used to calculate the odds don't account for the kind of madness and euphoria we saw in 1999. In other words, trading software assumes that all trading environments are always the same when, in many cases, they're not.

As a trader, you absolutely must be able to recognize when a particular trading system is ineffective because of an abnormal trading environment. This is tough to do, as it bucks the discipline that most traders have worked hard to develop. However, this skill will save you - and your account balance - a lot of pain.