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Three Laws Of Trading

02/14/13 12:43:15 PM
by Billy Williams

The stock market is doing so well that it appears too good to be true to some traders, but if you know these three laws of trading, you can come out a big winner in 2013.

Security:   SPX, V
Position:   N/A

The market has been on the move lately, registering the best January performance since the 1980s. The dreaded psychological level of the Standard & Poor's 500's 1500 level along with the Dow Jones Industrial Average (DJIA) 14,000 level have been confidently breached by traders, which leaves the all-time price high of both indexes within reach for the first time in more than a decade since the dotcom era's stock market gold rush that ended in early 1999. Today, what is at stake is the potential breakout to higher ground, ending the 14-year contracted price period that has been trying to repair the technical damage since that time. (See Figure 1.)

While there is a lot of optimism at the prospect of ending the lost decade of investment returns, a new generation is emerging that has no memory of being involved in the go-go 1990s, where gold dust was in the air and everyone from waiters to truck drivers considered themselves to be stock market experts. Now, there is an understandable fear that has settled into the hearts and minds of investors and traders who feel that the market has gone too far too fast, finding themselves in unfamiliar territory and wondering what to do in the present circumstances.

In this current environment, it's best to have a set of trading rules to help guide your thoughts so that you don't give in to irrational fears but have a model to guide them. To help, there are three laws of trading that apply to the market's current dynamic to help you navigate your way through a potentially momentous time in the financial markets.

They are: (1) the law of objectivity, (2) the law of following the money, and (3) the law of trading with the trend.

FIGURE 1: SPX. The SPX has been steadily climbing higher and higher, making some traders optimistic and other traders nervous. Objective reasoning is needed in these environments to make effective investment decisions based on facts, not fear.
Graphic provided by:
The law of objectivity is to put your emotions aside and stay grounded in reality. Traders often make predictions on what the market is going to do based on certain facts or fundamentals, but when the tide begins to shift against them, they overstay their welcome and end up poorer as a result.

While that is a common problem, the uncommon problem facing you is a market that has been rising at a steady clip despite the gloom-and-doom in the world today and there is the fear that a huge crash may occur. There are lots of talking heads speculating that the European debt crisis may reappear and/or the budget crisis in Washington may cause an economic decline, but no one can be certain.

FIGURE 2: V. Newton's first law of physics states that an object in motion tends to stay in motion, and so does the law of trading with the trend. Stocks like Visa are leaders into today's market and will take the market higher during bull runs.
Graphic provided by:
Will stocks crash like in 1999? Not likely. Currently, the Fed is printing money like crazy and fueling another bubble, but it's still in its infancy and investors are not overexposed or overinvolved in the stock market like the 1990s, which leaves a lot of room for the market to continue to trade higher. Possibly higher than anyone expects or has seen in the history of the US stock market.

Next, the law of following the money states that if you want to be on the right side of the market, then you have to see where the money is flowing.

Currently, individual investors are pouring money back into equities, and many stock leaders are trading at all-time highs and taking the overall market with them.

With no overhead resistance and demand for share rising steadily, the flow of money back into the market indicates that investor confidence is rising and likely to continue.

Finally, the law of trading with the trend is the oldest and most commonly stated law by speculators but, sadly, often the least heeded when the market is moving at a steady clip (Figure 2).

Most people are not wired correctly to make money in the market due to paradoxical thinking, where their best interests are often in conflict with their own irrational emotions, with their emotional side winning out.

Every major trading or investment figure will tell you that manic buying and selling is not the way to make big money during big moves like the one under way, but sitting tight on a confirmed trend is the way to make huge returns on your capital.

As the market continues to unfold, keep in mind these three trading laws -- objectivity; following the money; and trading with the trend -- and they will help you make better investment decisions and keep you from being swayed by conflicting news that is engineered from a position of fear, not fact. The market is facing a potential rebirth in 2013, which, if it develops, could usher in a renaissance for investors/traders for the first time in almost 14 years.

Billy Williams

Billy Williams has been trading the markets for 27 years, specializing in momentum trading with stocks and options.

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Date: 02/15/13Rank: 5Comment: 

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