Praise for Trading from Your Gut

Market Inertia and Momentum
Markets display inertia similar to physical objects. It takes some
force to start them moving in a particular direction, and after they
are moving, they tend to keep moving. Markets at rest tend to stay at
rest, essentially bouncing about a certain range. Markets that rise
tend to keep rising, and the same is true for descending markets.
Market momentum is derived from the underlying psychology
of the market participants. It is the result of a chain reaction, a con-
tagion of belief and perspective. This contagion requires an initial
trigger, but when an epidemic of buying or selling reaches a certain
point, it creates a reinforcing feedback loop. Buying creates more
buying, which creates even more buying. Selling brings more sell-
ing, which begets even more selling.
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Momentum in the markets is similar to a brush fire during the
dry season. It takes only a little spark to start things burning, and
then it becomes a self-sustaining phenomenon. The fire will slowly
grow as it reaches progressively larger brush. Eventually, it reaches a
point at which the heat from the fire is so high that it takes less time
for the flames to spread. The heat also creates an updraft that brings
in fresh oxygen and further raises the heat, creating a self-sustaining
feedback cycle. Fires that have reached a certain threshold burn out
only when fuel runs out or rains come. The amount and character of
fuel present often dictate the character of the fire itself. If the
underbrush is thick, the fire will burn hotter and faster. If the under-
brush is very dry, it will catch fire more easily and also burn hotter
and faster. 
Markets are much the same. Uncertainty is similar to the hot,
dry air that dries out the brush, and anxiety, fear, and greed are sim-
ilar to the grasses, brush, and trees that spread the fire. The greater
the price movement, the more uncertainty that movement will cre-
ate in the minds of those observing it. An individual trader will be
less sure that he can predict what the market will bring after it
moves in an unexpected manner. If he has no position in the market,
this increased uncertainty will likely keep him from entering the
market. If he has a position that was harmed by the movement, his
fear will increase.
Similar to the smaller twigs and grasses in a brush fire that are
easily set aflame, some traders reach the point of panic or fear more
quickly and more easily than others. So when the market drops sud-
denly, some traders will react fearfully, worried that they won’t be
able to sell. These traders will sell using market orders, which is a
trader’s way of saying, “I don’t care what price I get—just get me
out.” They panic.
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This panic drops the price further because the “sell at market”
orders result in trades at the bid price, which during a sudden price
decline is invariably at a price significantly lower than the last trade.
The bid drops far below the asking price because the level of uncer-
tainty of both the future price and direction of the market increases
during sudden market drops. The greater the uncertainty, the larger
the spread between bid and ask. In fact, this is one of the ways you
can measure the uncertainty implied by the market’s pricing. A
spread widening substantially indicates greater perceived uncer-
tainty in the market participants.
When the spread is wider after a sudden price drop, a market
order will result in a relatively greater drop in the price. And a group
of market orders placed at about the same time will result in a large
price drop, illustrating how uncertainty acts like the fuel for a brush
fire. If a lot of uncertainty exists, you’ll see much greater market
swings.
Similar to a brush fire, market momentum stops when
it has exhausted its fuel of fear, anxiety, and greed.
Similar to a brush fire, market momentum stops when it has
exhausted its fuel of fear, anxiety, and greed. As with a brush fire
that burns grasses and small shrubs but does not catch the large
trees on fire, some market panics are relatively small. Others, like a
brush fire that reaches the canopy of trees, spread to more seasoned
traders—those who are less prone to panic. Momentum takes place
on many different timescales. Examples include a very short-term
intraday movement in which a $50 stock might climb or plunge
20¢–30¢ in a few minutes, a medium-term intraday momentum in
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which that stock might climb or plunge 50¢–$1.50 during the course
of several hours, a short-term daily momentum in which a stock
might move 5%–8% in a few days or weeks, and a longer-term daily
momentum in which a stock might move 30%–40% or more during
the course of many months or years.
Sometimes the momentum from the different timeframes lines
up. You’ll get a short-term drop during the day, within a medium-
term drop, within a long-term drop. The U.S. market drop in late
September and early October 2008 was filled with days when panic
occurred at all timeframes. The level of uncertainty was very high,
and this led to continuing panic selling and very high volatility dur-
ing those weeks. 
Momentum doesn’t go on forever. When it slows, it generally
doesn’t stop; it usually reverses.