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to become an expert on crowd behavior. You only need to know what the crowd behavior is most likely to be at some point.
What motivates the crowd? I have spent a lot of time getting my think- ing around the concept of markets as a crowd, and I think I can say with some certainty that a market is in reality nothing more than an expression of three basic emotions: fear, greed, and hope. The other things that traders feel compelled to focus on as a support system to create confi- dence all boil down to a reason to hope, a reason to get paid, and a reason to pursue a profit with less fear. But the underlying emotional structure of the market is based on the need to avoid pain and the desire to make money. This is why traders are tempted to hope a market comes back when they are holding losses, why they hope a market continues further their way, why they get out if the market starts taking away an open-trade profit, why they hesitate to do the right thing at the right time, and all the other various behaviors that increase probabilities of net losses. The bot- tom line to all of this is trader behavior, and that behavior is driven by these three emotions.
Net winning traders still have these emotions, but they have one thing the losing trader does not: a deeper understanding of the crowd they par- ticipate in. Net winning traders also know that their behavior must be dif- ferent from the crowd’s behavior. This difference in behavior is the essential part of contrary thinking.
Almost all winning traders have controls on their behavior. That is what this book is really all about: giving traders a clearer understanding of where they need to focus their thinking and behavior. Creating your per- sonal daily trade rules comes from an adequate understanding of the psy- chology you need in order to achieve net winning performance. Net winning traders experience all the same emotions as losing traders, but their behavior controls prevent those emotions from becoming losing be- haviors. One of the absolute best controls you can develop is the propen- sity to stop thinking like the market crowd to begin with.
Most discussions of contrary thinking seem to focus more on learning to be bullish when the market is bearish, or vice versa. Actually, that is a useful tool, but I am not going to have that discussion. I am suggesting that contrary thinking is more about understanding that the crowd is thinking along certain lines and you need to think along a different line.
Sometimes that means you need to be looking at the bullish scenario when the market is declining; sometimes it means you need to fade the news; sometimes you need to stay away for a time.
The crowd behavior will almost always be driven by fear, greed, and hope, and those emotions are stimulated in the crowd by price action or the absence of price action. Remember, the prices mean something to
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each participant. When that meaning becomes an urge to action, a trade results. For example, if a market is declining against someone’s open long, that meansa trader is losing money. He wants to avoid that pain, so he will either hope the market reverses or get out if he fears a further price decline. Once that urge gets strong enough, the trader will liquidate. What does that kind of behavior look like in the actual market price action?
In your day-to-day analysis of the market, you would do better if you listened closely to the personal meaningsyou associate with price action.
For example, most traders tend to use the word strongto attach meaning to a market rising in price. Weakdescribes a declining market. Now, if you look closely at what you are doing when you attach meaning to a price di- rection, you have more clues as to how other traders, too, are most likely observing price action. In other words, the crowd believes the market is strong when prices are rising. What do you do with a strong market? You buy it, of course; strong is good.
At some point in this strong market the available universe of potential buyers will have come to that same conclusion and have placed them- selves at risk. They will have bought a position, correct? Now the market fails to advance. The buyer is afraid the strong market will now weaken and the potential exists for a loss. This fear now drives the buyer to sell, creating a self-fulfilling prophecy. If this whole dance happens with enough participants then the previously strong market now becomes weak and prices decline. The buyer has a loss—but the seller who let him in is the winner.
To be that winning seller is not as simple as being bearish when every- body is bullish; it’s more a process of knowing enough about average emo- tional thinking and how that will stimulate someone to do something. In the markets, you are looking for the point where that has already hap- pened. When the market has run out of buyers, it is physically impossible for that market to continue to advance—all the force that could be ex- erted on the buy side has already happened. All it takes is one seller to start the ball rolling the other way.
But in either case, the market is neither strong nor weak; it is simply a machine, processing orders in one direction or the other. What you are at- tempting to do is take advantage of the changing net order flow. That net order flow is created by the actions of each crowd participant. As each crowd participant comes to a conclusion and executes, the market is pre- set to go the other way sooner or later under some time frame; those initi- ating orders must eventually be offset with a liquidating order from the other side. Contrary thinking is about understanding that the crowd is do- ing one thing from the net perspective every day and that they will have to do the other thing eventually, maybe in a time frame you can see right
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now. In other words, once everybody has entered the market, they must leave the market sooner or later. You as a successful trader are attempting to be just aheadof that change in the net order flow; most likely that will mean a buy order when everyone is selling, or a sell order when everyone is buying. Contrary thinking is about being in the right place at the right time to exploit the crowd thinking.
It is important to remember that most people can come to a conclu- sion that is fairly accurate. Accurate thinking is not the same thing as ac- curate behavior. Many traders with only average understanding of fundamental and technical considerations can call a market. I am sure that you personally have come to the conclusion that a market was bull- ish or bearish, and that conclusion proved over time to be the right one.
Calling a market is not the hard part, in my opinion; the hard part is buy- ing or selling at the best times to capture the move. I am certain that some of my readers have been 100% correct on a market but didn’t make the potential gain for their account, or even had losses. The issue there is not the understanding of market potential; it is the lack of understanding regarding crowd behavior.
Most traders are not very skilled in reading the crowd well enough to know whenthe market is due to move the other way against the mostly right market call. In other words, wait for the correction or confirmation before entering the position; and that is often at the point when the early trader is liquidating with an early loss. Just knowing the underlying mar- ket potential is not enough to get in a winning position. You must also think differently about the same conclusion the average market partici- pant has come to. If everyone is bullish and the market is indeed rising, everyone is thinking the same thing: Get long, buy a pullback. But there will be a certain percent of bullish traders who will be washed out on that correction for various reasons and actually have a loss, even though they were right about the market. You want to be a buyer from those traders when they sell off their poorly set longs.
Knowing that potential going in every day is how you exploit the crowd’s behavior, and thatis contrary thinking. Contrary thinking is not coming to a conclusion that is different from other traders. It is not being bullish when everyone is bearish. Contrary thinking is about understand- ing the game so well that you know when it is time to go against the crowd. Your thinking process starts in a different place and you are not looking to be a bull or a bear in any market. You are attempting to out- think a crowd that does very little thinking in the first place. Sometimes that means you buy an upside breakout because you know the short has his stops up there; sometimes you sell into a rally because you know the crowd is buying the news; sometimes you stand aside because you know the bulls and bears are whipsawing themselves and you need to let the
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dust settle. Contrary thinking is more about thinking beyond emotional behavior, and then having the courage to exploit it without making the same mistake the crowd is making. In other words, you execute against the crowd when the time is right, and then you don’t panic, scare yourself out, cut a profit short, or hope the market comes back if you are losing.
You control your actions fully by discipline, but those actions come from a completely other kind of confidence.
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