Taking Advantage of Market Behavior

Trading can be a very satisfying way to make a living since you are your own boss, and solely responsible for the decisions you make, regardless of the outcome. Unfortunately this means if you lose, there is nobody to blame; even if you empowered someone else to make the monetary decisions, it was still your decision to do so. But if you win, you don't have to thank anyone, you can be secure in the knowledge that your success can be completely attributed to your own actions. This is one of the reasons so many people get into trading. The problem, however, is that to make money in the trading game you have to consistently buy low and sell high; to do this the you must make judgments concerning the direction in which the market is headed.

What is the Price?

This might seem obvious, but no matter what you are investing in, be it stocks, commodities, or derivatives, know the price you are paying, and know what the past prices have been. For example, you probably don't want to invest in gold at $600 an ounce if it's spent most of the past 10 years at around $400 an ounce. This is an important point, it's surprisingly easy to be seduced by the popularity of a stock or commodity without thinking about how much profit you are likely to make.

What is the Market?

It's common for people to think of a single entity when they think of ‘the market', but there isn't really a well-defined common meaning for ‘the market' in economic terms. The many indexes that make up the different components of the market go up and down independently of one another. There are, however, at least two indexes in particular that you should be aware of that are often referred to implicitly when discussing ‘the market' (at least, if you are speaking with an American investor):

• The Standard & Poor's 500 Stock Index (S&P 500 or SPX) is made up of 500 of the most prolifically traded stocks in the United States and represents something like seventy percent of the total value of United States stock markets.
  
  
• The Dow Jones Industrial Average (DJIA) is the oldest and best known index in the world. The DOW includes the stock of 30 companies whose annual revenues are each in excess of $7 billion and represents about a quarter of the U.S. stock market.

If someone says “their portfolio beat the market”, they are probably talking about the S&P 500; if you ask someone how the market is doing the answer will probably be based on the current performance of the Dow.

Psychology of Trends

History has shown time and again that the majority of the public are highly susceptible to trends, where a particular investment might enjoy huge popularity for a brief period. It's price will soar, and despite history's lessons the majority of the public will often follow the trend by investing in it, assuming the price will rise indefinitely. Inevitably, the trend wears off and the bottom falls out of the market, leaving many facing huge losses, while the few that got out while the price was still soaring made profits.

The Volume Factor

There is a type of "pack mentality" at work in the stock market. When traders sudden changes in a share 's volume (the number of shares bought or sold in a given period) tend to draw more traders onto the action for that stock. Volume is also measured for the entire market for any given period and is considered to be a leading market indicator.

Volume analysis if often used in an attempt to predict future movements in price before they happen. Because high volume can be on the buy or sell side, the most effective indicators compare "up" volume to "down" volume in order to determine which trend is prevailing in the market. This provides insight as to where the market is becoming overbought or oversold.

Advancing, declining, and unchanged volume

Advancing volume is the total volume for all securities who's price move higher. Declining volume is the total volume for all securities that declined in price. Similarly, unchanged volume is the total volume for all securities that were unchanged in price.

There two most common measures for Upside/Downside, or Advance/Decline Volume are:

The Upside/Downside Ratio
Upside/Downside Volume Line

The upside/downside volume line is tracked by recording a running total of the difference between the daily volume in advancing and declining issues. In most cases, the Upside/Downside Volume Line moves up and down with the share price. If the upside/downside volume line doesn't confirm a price move (known as divergence), it is a signal for a possible trend reversal.

The Upside/Downside Ratio

The upside/downside ratio is tracked by dividing the daily volume of advancing stocks by the daily volume of declining stocks. If the upside/downside ratio is greater than 1.0, it means that there is more volume for stocks that are increasing in price than with stocks that are decreasing in price.

When there are extremely high values, it may be an indication that the market is becoming overbought. Extremely low values, on the other hand, may indicate that the market is becoming oversold. Higher the upside/downside ratios, over 4 for example, indicate a bullish market while low readings, below .75, indicate a bearish signal.

When traders react to volume indicators it is called the Volume Factor.

The Market Crowd and You

The key to making money in any market is to understand the market crowd, or the average behavior of the individuals who hold stock in a given market. You don't want to follow the market you want to lead it by selling before the price drops, or buying before the price rises.

Hopefully the information in this article will help you to achieve this goal.

Next: Develop a Sound Trading Plan