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By: Chris Rowe — January 24, 2011

Are You "In The Closet"?

Every Tuesday (the day I write for The Tycoon Report), before the article, I will list one or two "test your knowledge" technical analysis questions and after the article I'll list the answers.  I hope you find this fun and I hope it helps you make more trading profits.  Sometimes small bites can have a huge impact.

Technical Analysis Question of the Week:

Below are three candles representing three days' worth of trading activity.

What is the name of the pattern, and/or what is the implication (bullish, bearish, neutral)?

(See answer below article)

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If you approach a new stock position as a full-fledged investor, then you would stay an investor and not even look at the price the market assigns to the company you bought (until the price is at least one penny above where you believe the company's valuation is "fair").  

The problem with that is most "individual investors" are "closet traders".

They have been trained to believe that trading is a method that involves much higher risk.  Therefore, they convince themselves, going into a position, that they are investors.  My counter to the notion that trading is a higher risk strategy is, as Warren Buffett says: "Risk is not knowing what you're doing". 

A person can "not know what they are doing" when it comes to either investing or trading just the same.  And it's actually much more likely that an individual doesn't know what they are doing when it comes to fundamental analysis -- and the thing about fundamental analysis is you hardly ever really know if you are doing it "right".

Technical analysis is the study of what IS happening.  Fundamental analysis is the study of what SHOULD be happening.

Since society has been convinced that investing is safer than trading, they start out entering positions telling themselves they are doing the "prudent" thing:  Investing.

There are two main reasons individual "investors" enter into positions believing themselves to be "investors" ...

1.  Because "trader" has been viewed by much of society as a dirty word to describe high strung risk takers or emotional decision makers.

2.  They find it easier to buy into a great story that's easy to digest than to learn what all those squiggly lines in technical analysis mean. 

They might even dig into the industry that the company they are buying is in.  They may listen to some quarterly conference calls, read some analyst reports, check the Price to Earnings Ratio and the return on invested capital, and calculate whether quarterly earnings and revenue are accelerating quarter over quarter. 

There is nothing wrong with doing these things.  In my opinion, it's best to combine fundamental and technical analysis.  But when investors use these known facts as a substitute to understanding, technically, what's going on in the general market, the company's industry, and the company's price charts, they are usually lying to themselves.  Why?

When the stock turns south, the individual realizes that she no longer cares about what the story is -- she just wants out.  Or worse, she sticks to her guns, claiming to be an investor when the real reason for staying in the stock is that it's too painful to admit the mistake and sell the stock.  

If you have analyzed a business and its industry thoroughly enough, and are confident enough in your ability to make a determination of its valuation, then the stock's decline shouldn't bother you much.  Since hardly any individual investors truly have the skills -- and confidence in their skills -- to determine whether a company is undervalued, and to invest in that company, they suddenly turn from "fundamental investors" into "technical traders" and sell.

As an "investor", you are much more of a fundamental player than a technical player, so you are saying "the market" (mostly everyone) is wrong about the currently assigned valuation, and that you are right.  OR you are saying that you are right, and almost everyone else is wrong except, perhaps, for some other fundamental players who either:

a.  Have been buying that company's stock very quietly and unnoticeably because they are big players trying not to alert the public, or ...

b.  Because, like you, they are individual investors who are savvy enough to understand a public company's valuation better than everyone trading it, yet not big enough to move the price of the stock even if they invested their net worths in it.

I'm guessing, at least 199 times out of 200, individuals buy "companies" and sell "stocks".  They don't stick with the "companies" they've purchased 0.00001% of when they see the market disagreeing (by selling the stock and pushing prices lower).

Don't think I'm picking on fundamental analysis or on fundamental analysts.

My point is the same if you reverse the fundamental and technical players' roles.

If you're a trader, you have to treat stocks like toilet paper.  You can't buy in to a position because of a breakout of a chart formation, sector demand, momentum buy signals, and moving average crossovers, only to exit (or hold) the position based on the company's fundamental prospects. 

I can't tell you how many times I've seen someone get into a position because the technical picture looked great, but then when the stock went the wrong way, they suddenly started talking about the PE ratios and earnings prospects as a reason for holding the technically broken position.

The important message here is this ...

MISTAKE:  Considering yourself an investor or a trader when it's most convenient for dealing with your emotions at any given time. 

REMEDY:  Setting the rules before entering the position.  When you enter into a position, be sure to make the decision right then and there on what the plan is going to be. 

Decide ahead of time if you are going to use a combination of technical and fundamental analysis.  It's best to find positions that are on fundamentally strong companies, and to use technical analysis to time the purchase and sale of the positions.

If you don't understand either, then learn more about both.  But it's best to first learn about technical analysis and then move on to fundamental analysis, because you can trade and invest using technical analysis. 

With technical analysis, you are acting based on what is actually happening right there in front of your face.  With fundamental analysis, you are forecasting what you think will happen by determining a valuation that the rest of the world disagrees with, and you believe they will eventually realize that they are all wrong and that you are right.

Personally, I'd rather be rich than right.

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Answer (to TA question from above the article):

The pattern is called a "morning doji star".  This is probably the single most potent and reliable 3-day bullish reversal pattern.

The top of the thick part is the open, the bottom of the thick part is the close and the thin "wick" parts of the candle represents the daily high and low.

The first day is a large down day.  The second day is the "doji star" itself.  It's not only a doji (which opens and closes at the same price, and therefore has no real body), but it's a "star" because the opening price of the day was lower than the previous day's low.

A morning doji star is confirmed with a strong white candlestick that moves well into the first candlestick's real body. 

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