Wednesday, May 29, 2013

The chicken or the egg

There are a lot of traders and investors who will refuse to open a position in a stock if they do not understand the underlying fundamental situation, or even if there is no such information available. However, doing this will mean that potentially you could miss out on some great trading opportunities, and therefore profits.

So what comes first - fundamentals or price movement - chicken or the egg? I'm in the camp who believes that price movements more often than not precede news. I believe that all known fundamentals would be priced into the current price of a stock. Prices can be affected by other factors such as general market conditions, as well as the actions (buying and selling) of other traders and investors, or the expectation of future events depending on future forecasts.

Perhaps the best example of this was the dot.com boom in the late 1990's and early 2000. There were plenty of people who refused to have positions on the tech stocks. As it turned out, there were dozens of companies who had no earnings whatsoever, but the stock price didn't know that. If you were able to control your risk and simply follow the trend of the price, then great fortunes were made.

Unfortunately, the bursting of the bubble together with the realisation that many of those companies would never make money meant that lots of those fortunes were lost, as those traders never had an exit strategy when the price trend started to reverse.

We also see this when a company with seemingly solid fundamentals starts to see it stock price change direction and start a downtrend. Some people see this as a 'buying opportunity'. Others (such as me) would see it as a signal to either exit their position and bank their profits, or maybe as a signal to go short.

In these cases, a simple trend following system would have got you out near the top of the market, and would also have given you the signal to even go short as well. The same thing would have meant profiting from both the uptrend and downtrend in Enron. There are countless other examples over the years of price movements such as these.

These should act as a reminder that, while other factors (known or unknown) may act as a catalyst,  it is price movement and price movement alone that makes you a profit on a trade or investment.

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