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Emotions and the Stock Market

Let's call our first character "Mr. Snow." This highly successful man was one of my colleagues; he worked as a trader on the floor of the Montreal Stock Exchange, at a time when the exchanges still engaged in this type of activity. He was employed by a major brokerage firm. He arrived one morning in the lobby of the Stock Exchange Tower in Place Victoria – where the stock exchange is still located today – and called the elevator to go up to the trading floor on the third floor. In front of him were three elevators, which prompted him to devise the following theory: if the doors of the right elevator were the first to open, the market would rise that day. If the left elevator arrived first, the market would fall, and if the middle elevator was the first to arrive, the market would be flat. He said this method worked very well. I don't think he really believed in this theory; in fact, it was probably a diversion he created to satisfy people who asked him what his work method was. Seeing him, day after day, trading tens of millions of dollars worth of stocks, I figured this imperturbable, silent man must have an excellent method – a secret method – to be so successful.

We'll call our second character “Mr. Rain.” He was an independent trader who specialized in the gold market early in his career. It was said that after working for many years for a carpet manufacturer, he decided to change careers. After acquiring a trader's licence, he began trading stocks and options , and quickly became famous. Articles in the press described him as a "modern-day Midas," the mythical king who transformed everything he touched into gold. Mr. Rain’s fame didn't seem to affect him: he spent his days on the trading floor watching the price of gold on his computer screen and doing crossword puzzles in the daily newspaper, without saying a word. The only time this solitary man showed any emotion, it was said, was the day his wife surprised him at work by asking for a divorce. That day, he apparently lost $40,000 in a few minutes; it was as if the news short-circuited his extraordinary capacity to generate profits.

At the time, computers didn't produce charts, so traders had to draw them by hand. With a pencil, they drew support and resistance lines, which they then erased once these levels had been broken. But Mr. Rain never drew charts; he simply watched the quotes crawl across his screen. Perhaps he knew the support and resistance levels by heart and drew the charts in his head.

Whenever he was asked about his trading method, Mr. Rain would reply that it was essentially based on intuition – a gut feeling – and he would then change the subject.

Over the years, I became closer to these traders. One fine Monday morning, Mr. Snow asked me if I had a good weekend. He told me that his child's team was playing a game at the local arena. Mr. Snow's wife had set up an ice cream stand for the players and their parents. When Mr. Snow helped her out, he discovered that the job of ice cream vendor was not nearly as risky as that of a stock trader!

A few years later, more specifically on October 19, 1987, the stock market lost close to 23% of its value in a single day. It had already fallen the previous Friday, but no one could have predicted the ensuing collapse. On that Friday, at the end of the day, Mr. Rain, with his usual simplicity, said, “Today, the little bear came out of its den, so its mother can't be far behind." A bear, as we know, symbolizes a falling stock market. The following Monday, the market suffered its biggest one-day loss ever, apart from what happened during the 1929 Crash.

The Dow Jones Index, from June 1987 to January 1988

On that Monday, October 19, while panic swept the trading floor, an unmoved Mr. Rain was, as usual, seated at his post, intently watching his screen. It is said that he made fabulous profits that day, perhaps $500,000, maybe $1 million. No one knows exactly how much. His attitude hadn't changed at all, and he hadn't said anything to anyone. A few weeks later, he confided to me that for several months, more precisely since April 1987, he was convinced that the stock market was going to fall. So he bought out-of-the-money puts on indices and stocks, and he waited, like a hunter who places his traps and waits for his prey . Day after day, week after week, Mr. Rain waited silently, while around him, investors were euphoric. After many years, the market was finally rising, and everyone was convinced it would go even higher.

Mr. Snow and Mr. Rain taught me that a placid exterior can sometimes hide a completely different interior, one marked by deep convictions for which these two men suffered and fought daily: Mr. Snow made money for himself and for his brokerage firm because he had a method that he stuck with and because he never overestimated his abilities, hence his humility; Mr. Rain silently and almost secretly bought puts that went against the general consensus because he had strongly held beliefs. To avoid being influenced by others, he never spoke to them and he never asked them anything.

Mr. Snow and Mr. Rain made money simply because they used their common sense, a commodity whose importance cannot be overestimated. After all, their training was almost nil compared to the average level of education of today’s traders. Our two men were interested in neither the economy nor finance.

Today, statistics show that we concentrate for only 56 seconds on the same subject, because we are continually distracted by emails, cell phone calls, television, news, and the opinions of “experts.” We may sometimes lack depth in terms of our ability to analyze and process information, because we use our brains more to receive and distribute information than to think. In the time of Mr. Snow and Mr. Rain, cell phones and the Internet didn’t exist, and laptop computers had only just arrived on the market (they sometimes weighed as much as 10 kilos!). We must learn to insulate ourselves from all the background noise of modern life, so that we can better concentrate and remain calm.

In short, we cannot avoid emotions, because we are human. However, we can control them to a large degree. Here’s how:

  • You must have a trading method.
  • You must not read the “Economy” section of the newspaper.
  • You must not watch the financial news.
  • You must not seek the opinion of “experts,” because market experts don’t exist. Many people, like journalists, erroneously believe you can become a stock market expert the same way you become a doctor or a lawyer.
  • When you listen to the opinions of others, you become dependent, insecure and anxious.

In closing, let’s talk about the ideal diet for an active stock trader. Because the stock trader is more subject to emotions, he or she should eat light. Here are some suggestions:

  • Eat grilled chicken and organic vegetables and fruits. Slices of Kraft Fat-free Singles (Kraft is a Dow 30 company) are a good source of protein, containing five grams for only 30 calories.
  • Avoid very salty foods.
  • Don’t eat in front of a computer screen displaying stock quotes, because you may not be able to control the number of calories you ingest.
  • Remember that a light stomach helps you control your emotions.

1 The present document is provided for information purposes only and is intended for sophisticated investors whom have extensive experience in trading options. Investors should review the document that describes the risks inherent in negotiating options «Regulatory disclosures and information on asset protection». Options are not suitable for all type of investors.

2 A put increases in value when the underlying stock declines. An out-of-the-money put starts to generate profits when the stock falls, for example, to $90, when it is normally at $100. This type of put is generally very cheap, because the stock must suffer a substantial initial drop before it starts to generate profits and it must then continue to decline. If the market plummets, a small initial investment can yield a huge profit. Note that if the stock price does not decline, the investor may lose the initial investment.

The author

Charles K. Langford

Charles K. Langford

PhD, Fellow CSI

Charles K. Langford is President of Charles K. Langford, Inc, Portfolio Managers. He teaches portfolio management at School of Management (École des Sciences de la Gestion), University of Québec (Montréal). He is the author of 14 books on portfolio management, derivatives strategies and technical analysis.

Until 2007 he has been vice-president overlay risk management for Visconti Venosta Teaspoon Approach Management, Ltd. Until 1990 he was portfolio manager for Refco Futures (Canada) Ltd.

He has received a Bachelor degree from Université de Montréal, a Master degree and the PhD from McGill University (Montreal); he is Fellow of CSI (Canadian Securities Institute).