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TRADER'S NOTEBOOK


Caveat Emptor: Buyer (Or Seller) Beware!

07/13/05 03:22:14 PM PST
by David & Anna Coulling

A supply and demand parable for the individual trader.

One day after a particularly spectacular trading debacle, my Uncle Joe took me aside and consoled me with some hard facts about how the stock market works. You see, Uncle Joe owns a very unique company and has an insider's perspective on how stock price movement is managed.

His company, Widgets & Co., is the only company in the state that distributes widgets, and it does so under license from the government. It has been buying and selling its unique widgets for many years. Now imagine also that these widgets have an intrinsic value, they never break, and that the number in circulation at any one time is the same.

So, Uncle Joe, being a clever man with many years of experience managing his business, realized early on that just buying and selling his widgets to customers was, in fact, rather dull. The amount of money he made each time he bought and sold was quite small, and the number of transactions per day was also low. In addition, he also had all the running expenses of his office, his warehouse and his staff. Something would have to be done.

Having given the problem some thought, he wondered what would happen if he mentioned to a neighbor that widgets could soon be in short supply. He knew his neighbor was a terrible gossip, so this was nearly as effective as putting an advertisement in the local paper. He also knew from checking his warehouse that he had enough stock to meet any increased demand should his plan be successful.

The following day he met his neighbor outside and casually mentioned his concerns, begging the man to keep it to himself. His neighbor assured Uncle Joe that he wouldn't breathe a word; his lips were sealed.

Several days passed and widget sales remained at their normal level. However, after a week or so, sales started to pick up with more customers coming to the warehouse and buying in larger quantities. It seemed his plan had worked and everyone was happy. His customers were happy as they knew that widgets would soon be in short supply and so their value would increase. Uncle Joe was happy because he was selling more widgets and making more money every day. Then he started to thinkwith everyone buying his widgets, what would happen if he raised his prices? After all, he was the only supplier and demand was high at the moment.

The following day he announced a price increase, but still believing there would soon be a widget shortage, his customers continued to buyin ever larger quantities!

As the weeks passed he gradually increased his prices higher and higher, but still the buyers continued to buy. A few of his more astute customers started to sell their widgets back to him, taking their profits, but Uncle Joe didn't mind as he still had plenty of willing buyers.

This was all good news for Uncle Joe, until one day, he suddenly realized with some alarm that his warehouse was now looking very empty indeed. He also started to notice that the volume of sales each day was decreasing. He decided to keep moving prices up, so everyone would think that the situation was unchanged.

But now he had a new problem. His original plan had been too successful. How on earth was he going to persuade all his customers to sell widgets back to him so that he could continue in business?

He pondered his problem for several days with no clear solution. Then, quite by chance, he met his neighbor one day in town. The man drew him to one side and inquired whether the rumor he had heard was true? Inquiring into what that rumor might be, Uncle Joe learned that his neighbor had heard that another, much bigger widget distribution company was setting up business in the area.

Being clever, Uncle Joe realized that providence had given him the answer on a plate. Appearing crestfallen, he admitted that the rumor was true and that his business would suffer badly. More importantly, widget values were likely to drop dramatically in price.

As they parted company, Uncle Joe chuckled to himself at having such good fortune and such a helpful gossip for a neighbor. Within days he had queues of customers outside his warehouse doors begging him to buy back their widgets. With so many people selling, he dropped his prices quickly, making people even more desperate to sell before their widgets became worthless!

As the prices fell further, more and more people cracked under the pressure. Uncle Joe was now buying back an enormous volume of widgets. After several weeks the panic selling was over, as few people had been brave enough to hold out under the pressure.

Uncle Joe could now start to sell widgets again at their old levels from his warehouse full of stock. He didn't mind if it was quiet for a few months as he has made a great deal of money very quickly. He could afford to take it easy. His overhead expenses were covered and he could even pay his staff a healthy bonus. Everyone soon forgot how or where the rumors had started and life returned to normal. Normal that is until Uncle Joe started thinking one dayI wonder if we could do that again?

WHAT'S THIS GOT TO DO WITH TRADING?
The answer, of course, is everything. To most people, the sudden moves seen in the stock market are a complete mystery. Movements seem to be heavily influenced by news and appear when least expected. The market seems to turn upwards when news is at its worst, and start falling when there is lots of good news. The market often does the exact opposite of what you feel it should be doing, or what your instinct tells you it might. More curious is when good news appears and the market or stock falls, or equally odd it rises on bad news or results. Stranger still is the fact that the market always falls faster than it rises. You might think this has something to do with gravity. It does not!

If you have the time, tune in to Bloomberg radio, and listen to the variety of experts who are wheeled out each day, everyone from economists to fund managers, each expounding on their latest take on the market and where it is going in general. These so-called "professionals" are paid to know what is happening and why, and advise major institutions and corporate clients where and when to invest, yet even they cannot agree. I guarantee if you listen long enough you will hear 10 different views from 10 different people. Some will favor the bear side, others the bull. Some will favor technology stocks, others will avoid them like the plague.

You will find these professionals in any business involving huge amounts of money and massive potential profits. As a private trader or investor you will be playing against these professionals and if you don't know how the game is played — beware! But please don't bother shouting foul — no one will hear you, least of all care. They don't know you and will take your money without a second thought.

If you think my Uncle Joe's story is fiction, think again. Many companies like Uncle Joe's are involved in the market and collectively they are known as the market makers, impacting the market every hour of every day of every week that the market trades. With over three hundred years of collective expertise, they have definitely reached professional status. To trade successfully in the market, you need to start thinking like they think.

So, finally, let me leave you with the chartist's prayer:

May my assessment of today's price action be based upon the facts, all of the facts and nothing but the facts. May I not be influenced by fear, greed or the ill advised comments of others, which may be made in their interests and not in my own. May I take into account the past history laid before me on this chart and make my assessment based on my knowledge and logic, and not on my emotions

SUGGESTED READING
Coulling, David and Anna [2005]. "The Inner Trader And You," Working-Money.com, April 7.

Current and past articles from Working Money, The Investors' Magazine, can be found at Working-Money.com.





David & Anna Coulling


E-mail address: avanti@ukonline.co.uk


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