Thursday, June 4, 2009

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Buy Low and Sell High: Why You will Not Succeed in the Long Run with This Myth?

What is the first idea everyone gets from their intelligence after looking at the stock market? Why do many traders get stuck in their first trades? Why do only few traders actually succeed in the long run in the stock trading business? At the root of all these questions lies a fundamental paradigm of stock trading. This is known as buy low and sell high. Let me assure you that if you believe in this theory, you will someday have to close your trading account!

buy low and sell high is not so simple as it seemsImage Source

This is a Truly False Theory

You may be surprised to see me call this basic belief as a myth. But it is the reality which is like a violent ocean that traders have to cross before their journey can become smooth. Very few traders cross over this myth and learn the right belief. This buy low and sell high is a concept very popular and obvious for almost every stock trader or investor on the planet. Even the people who do not trade stocks understand this theory or make it on their own.

This is also one of those false theories people make immediately from their experience. It is so obvious a theory that it does not really do what it appears to do on the outset. Let me take you on a journey to debunk this myth and explore what is the right paradigm.

A Stock Trader’s Interaction with the Stock market

Whenever you think of trading stocks in general any business involving buying goods and selling them later, you can easily understand and follow that to make profits you should buy the goods at a lower price and sell them later at a higher price. The difference in price is the profit that you get to keep for your financial growth or survival.

But when it comes to trading stocks this simple theory becomes a stupid theory. It is no longer the same case with stock markets which involve highly complicated day-to-day phenomena. The basic problem with this belief is that it makes you ignore a fundamental aspect about how a trader interacts with the stock market.

There are four things a trader does when he/she comes to stocks. They are:
  1. Sitting on the sidelines before entering a stock
  2. Buying the stock at entry point
  3. Holding the stock for some time before exiting
  4. Selling the stock at exit point

Now each of these four things is equally important. But the amount of time each one takes is quite different from the other. A trader has to most likely do each of these activities for closing every single trade in and out.

Buying and selling take just a few seconds of your time while sitting on the sidelines and holding the stock are what a trader spends most of time on. It is very tempting to buy and sell stocks than waiting without doing anything other than watching stock movements.

Buying Low and Selling High…

Many beginners get caught up buying and selling stocks at the flash of thought. They don’t have a reason to do that. They just do this repeatedly for the sake of momentary pleasure that comes immediately after action. Considering this it is actually better to think of buy low and sell high a stock. In fact these beginners slowly realize this principle on their own after several unsuccessful trades.

It also makes sense a fundamental principle in making profits in a business. By sticking to a strategy as simple as these is also a good thing for many traders. A trader should always focus on long term consequences of his/her actions than doing things out of instinct or for momentary pleasure.

But the fact is that those who begin without this theory and those who learn that this theory is a myth are better off in the long run than those smart traders who learn this theory. The beginners atleast stop trading after their first losing streak and spend their time on doing other better things. The successful traders do not believe in this theory and always are on the next good bets. So they continue for the long term success.

But the traders in between who believe this theory at heart at the people who struggle all along their trading career going up and down with the stock market. They just react to the market and not ride the stock market.

Why This is a False Belief…

Let me get to the reason why this belief is not correct. In my trading I started thinking about these just after first few trades when some of them resulted in a loss that I took or yet to take. I realized that I had to carefully buy the stock when it is low and sell it after it goes high. It looked like a very smart and fundamental strategy.

But the low and high prices of a stock are only relative. You cannot really buy a stock at its lowest price and atleast not every time. Also you cannot sell a stock at its highest price and atleast not every time.

When a stock is moving in an uptrend any price is a lower price compared to future price. If you wait for the stock to come from its current price, it may not easily come unless it changes its trend for a longer time. When it does you may be too quick to enter into it.

For example, a stock at 400 appears too high if you looked at its past prices to be less than 400. If it is in upward trend, then the next days it will go up to 420, 440 and so on. Once it goes there you will see 400 as low price. See how relative it is.

As the stock moves up and up it will may be around 500 when it takes a turn back. And you will be tempted to enter into the stock at any price below 500 because all are now relatively lower prices. If you enter at 480, it does not mean that the stock has made a low there. It can down again to 460… 440 and so on. You may even buy more stock to do averaging the stock price. When it does move up any price above your buy price seems high and you will end up selling too early after seeing a little profit.

You might have sold at 480 which will be higher than the average purchase price or 500 or 520. But when a stock can move from 400 to 500 in a single leap in the current trend, it will again make such a massive move in the next leap moving from 500 to 600 or 620. Can you recollect doing similar thing in your experience?

In reality many traders end up doing like this. They are anyway happy for taking a profit though they regret for not staying for a little more time. What they miss to see is that this profit is less than what market is giving. By undermining their profit potential they become vulnerable to risks.

The Risk Side or the Real Dark Side of it!

Let me come to the risk side of this belief. The biggest problem with this principle is that people end up being caught in the fall of a stock and just cannot get out when a major trend reversal happens.

Imagine the days of January 22 and 23 and also the months of July or August. The stocks were falling everyday. They were becoming lower and lower everyday. If you believed this theory you would have bought at any price because they are lower than their all time heights they reached just a few weeks back. But the stocks did not stop there. They continued to fall and still below their high prices. Some stocks are much farther from their highs, actually.

So when you think of buy low, you will buy the stock at low price when it starts to slide after making a high price. This is a reactive approach. Of course this is not very bad idea because sometimes it can work like safety cushion. It is always good to buy stocks at lower prices.

But what happens if the stock goes lower and lower after you buy? I used to think of another myth called averaging stock price and keep buying more on “every dip”. But how much can you buy? You will be drained of your capital in only a handful of trades.

If you think that you will use a rule to handle this situation, think again. If the stock were to go down two times, you need to buy two times. You may do a 1:1 or 1:2 division of your capital for these two buys. That means you need to buy with a lesser price first so that second one will have enough weight to average.

If the stock were to go down another time, you will have to buy with even lower price. This is not practical because the stocks do not always follow a consistent pattern. You may be good in trending markets, but when they change trend you will caught up in that. And may lose all you made or even your original capital if you had just started in a single go.

The Theory itself is Dependent upon You

The concept of buying low and selling high is not wrong by itself. It becomes inappropriate when considering the trading environment and your other beliefs or reactive behavior. No trader is ideal and no stock is ideal. Things do not need to happen as we wish them to.

Considering that this theory is also dependent on your other beliefs or paradigms, I want you to understand the long term implications of this theory. This is really a big problem if you fail to recognize a trend reversal.

Most of the people, who followed it during the downturn of the last year, are the people who are deeply in trouble today. Those who recognized the trend reversal and got out of the market have some relief despite some losses.

Go Beyond the Obvious...

Go beyond the obvious things and separate yourself from the rest of the crowd. Low and high are always relative terms in trading stocks. You should not fall for a falling stock as it becomes lower and lower. On the other side you should not sell a stock quickly because it is now higher than ever before. Most often a stock making a high price continues to make highs before it does a major trend reversal. Getting out too early is disastrous for the long term.

Even if you limit losses in failed trades, low profit trades can kill your chances of long term success. Why would you spend time trading if you were only to survive? To me that is just a waste of time.

Go beyond the obvious high and low prices. Appreciate their relative nature and accordingly look for long term high and low prices. In other words you can follow buy high and sell low for a successful long term strategy. I will explore this in the future posts.

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