Post by He Shuhan on May 7, 2006 23:01:00 GMT -4
The following is a collection from Mr Don Worden, one of the best traders I have ever known in my life. Everytime I look at his articles I feel like a small fry and get energized by the seemingly endless zeal to trading which he, at more than 60 years of age, possesses.
It all started with a question posed by someone (which happens to be the question I was pondering for the month)
Don,
Do stocks fall because of an absence of buying or because of a preponderance of sellers? Can short sellers alone cause the stock of a large company to fall or are they just gaining when the longs stop buying?
Thank you,
Lawrence
That's an excellent question, Lawrence. Before I can answer it directly, I have to lay a little groundwork. My observation is that investors assume that stocks go down because "there are more sellers than buyers." Many people who write about the stock market seem to harbor the same impression. But, of course, this is absurd, because for a transaction to take place there must be a buy side and a sell side. In an oversimplified but valid sense, it is valid to say, "For every buyer there must be a seller and for every seller there must be a buyer."
Once having purged ourselves of that widespread delusion, how exactly should we describe the forces of supply and demand in moving stock prices? We must start with potential buyers and potential sellers. If there are more potential buyers than potential sellers, chances are the buyers will be forced to compete with each other and will be inclined to reach up for the stock. The sellers, on the other hand, are apt to hold out for better prices. Some of the buyers will not be able to consummate transactions. The price will rise.
If there are more potential sellers than potential buyers, the sellers will tend to cut their prices, while the buyers hold out for bargains. Some of the sellers may not be able to sell at acceptable prices.
So far, so good. But your question still hasn't been answered. "Do stocks fall because of an absence of buying or because of a preponderance of selling." I think the conventional wisdom is that declines are driven by overwhelming selling interest. I don't think so - not usually anyway. Markets generally fall of their own weight - that is, they fall because of a dry up in buying interest. Now, there are times when a surge of selling will push the market down - but only temporarily. A typical example would be at an important bottom, when panic leads to the irrational dumping of stock in what used to be called a "selling climax." Today is more often referred to as "capitulation." No matter what you call it, it doesn't last long and it is ended by a surge of astute buyers who recognize the emotional chaos in this situation.
But in general, the long, middle part of an important decline is characterized by a dwindling interest in buying. The selling is also apt to dwindle, as buyers and sellers are both waiting for the same thing - and that is a bottom.
For most companies, the majority of stockholders are predominantly "permanent" investors in the company's business. They're not in there to speculate, and they are not potential sellers in response to short-term fluctuations in the profitability of the business or of the stock price. Those who do respond to such stimuli are marginal in numbers. But on the outside looking in are a horde of potential buyers. When they lose interest, the result is a dry up in actual buying.
Let me end with a shocking contention: Supply versus demand does not always play a significant role in the price movement of stocks. There is another phenomenon, which, oh so many years ago, I gave a name to. I call it "spontaneous adjustment." The best example of this is an x-dividend adjustment. It is automatic because of a tacit agreement by all parties that the stock is now worth less, specifically by an amount equal to the dividend to be paid. Any time a stock becomes worth less or more in an undisputable amount (as in a merger, for example) a "spontaneous adjustment" takes place. And, many price moves are almost automatic, and take place through a combination of "spontaneous adjustment" and "supply versus demand."
As to your second question, can short-sellers alone cause the stock of a large company to fall? I'm inclined to think the answer is no, but I suppose it's possible for a limited period of time, particularly since hedge funds have become such a big force in the market. But remember, every short seller has to eventually buy that stock back, which means he may inadvertently become a potent source of demand.
We have some hedge-fund operators out there. Maybe one of them will volunteer an answer to this question. -DW
Don,
Short-sellers alone can't cause the stock of a large company to fall any more than long-buyers alone can make it go up. Anyone that assumes asymmetry between long-buyers/short-coverers and short-sellers/long-sellers has spent too much time on the Yahoo message boards trying to "get shorty". Or easier yet, let me ask your readers the question another way: which is more likely to make a large company stock fall...Fidelity selling long 5mil shares of stock, or XYZ Hedge Partners selling short 5mil shares of stock...or easier still, which seller will require an uptick? Regards,
Sean, CFA
[Editor's Note: The above memo came in response to our request for a hedge-fund strategist to explain whether short-sales alone could cause the stock of a large company to fall. For those who aren't familiar with the "uptick rule," short sales can be executed only on or following an uptick. ETFs are exempt from the rule. And, of course, the selling of shares from an ordinary long position is not bound by any such rule. -DW]
Don,
I have never failed to be astonished that anyone can believe the "more sellers than buyers" fallacy, and I am glad to read your de-bunk.
However, the Worden report did not mention the role of the Market Maker, who actually is the buyer and the seller. We all deal with him, so why is he so seldom mentioned when this subject is raised?
The Market Maker sets the price at the level which he expects will produce maximum volume. It only needs the MM and one retail trader to do business. The MM has the ability to balance his books by laying off the risk of the long or short position in the few seconds which follow the trade.
A study of gaps confirms the truth: When a gap event occurs, the MMs will often gap the price to an extreme, and then sweep the price across the gap to take the trades of all those who have been stimulated to deal by the gap, like trout jumping at an emerging fly.
Some time ago, I studied the London closing auction. A retail trader can post a buy or sell order with the price at which he is willing to deal, and may or may not be filled. After the closing bell, the MMs match bargains. Here at last in after hours trading, we have a situation which needs both a buyer and seller.
Regards,
John (Sir Limey - submissions on Ap 6 2001 and Ap 5 2002)
[Enjoyed your observations, John, but I doubt that that here MMs can arbitrarily induce a gap opening. Gaps can only be justified by significant imbalances in supply and demand. I have heard about "Mad Dogs and Englishmen," but I didn't know it extended to MMs. - DW]
Hi Mr. Worden,
I enjoy reading your Daily Worden Reports. Thank you for sharing your wise insights into the markets.
I also enjoyed reading Wednesday's submission by Sir Nine-Steps. Clearly he is a good investor. I particularly liked his reference to the 8% stop loss he uses based on a stock's hi-closing price. I have been thinking about using trailing stop-loss orders as well, but have been uncertain as to what percentage to set the stop-loss.
This weekend I am going to do some back-testing on my previous trades etc to see if this percentage would have worked well for me as well.
Thanks again for your keen insight and terrific software.
Sincerely,
Ray (Sir RWPOD, knighted on 3/17/06)
Sir Nine-Steps uses a volatility adjustment to control position sizing. I edited it out of his otherwise excellent submission, because it was too difficult to understand and would probably have caused confusion. Keep in mind that, if you are going to use a set percentage loss-cut, you should increase the percentage for volatile stocks and proportionately decrease the percentage for low volatility stocks. (You would have to develop a formula for that.) Otherwise you will frequently be stopped out of volatile stocks prematurely and out of low volatility stocks too late for optimum results.
Frankly, I think you will do better using the loss-cut system I publish from time to time. It is based on progressively protecting growing profits. I believe it was last published in the Worden Report of March 28, 2005. - DW
It all started with a question posed by someone (which happens to be the question I was pondering for the month)
Don,
Do stocks fall because of an absence of buying or because of a preponderance of sellers? Can short sellers alone cause the stock of a large company to fall or are they just gaining when the longs stop buying?
Thank you,
Lawrence
That's an excellent question, Lawrence. Before I can answer it directly, I have to lay a little groundwork. My observation is that investors assume that stocks go down because "there are more sellers than buyers." Many people who write about the stock market seem to harbor the same impression. But, of course, this is absurd, because for a transaction to take place there must be a buy side and a sell side. In an oversimplified but valid sense, it is valid to say, "For every buyer there must be a seller and for every seller there must be a buyer."
Once having purged ourselves of that widespread delusion, how exactly should we describe the forces of supply and demand in moving stock prices? We must start with potential buyers and potential sellers. If there are more potential buyers than potential sellers, chances are the buyers will be forced to compete with each other and will be inclined to reach up for the stock. The sellers, on the other hand, are apt to hold out for better prices. Some of the buyers will not be able to consummate transactions. The price will rise.
If there are more potential sellers than potential buyers, the sellers will tend to cut their prices, while the buyers hold out for bargains. Some of the sellers may not be able to sell at acceptable prices.
So far, so good. But your question still hasn't been answered. "Do stocks fall because of an absence of buying or because of a preponderance of selling." I think the conventional wisdom is that declines are driven by overwhelming selling interest. I don't think so - not usually anyway. Markets generally fall of their own weight - that is, they fall because of a dry up in buying interest. Now, there are times when a surge of selling will push the market down - but only temporarily. A typical example would be at an important bottom, when panic leads to the irrational dumping of stock in what used to be called a "selling climax." Today is more often referred to as "capitulation." No matter what you call it, it doesn't last long and it is ended by a surge of astute buyers who recognize the emotional chaos in this situation.
But in general, the long, middle part of an important decline is characterized by a dwindling interest in buying. The selling is also apt to dwindle, as buyers and sellers are both waiting for the same thing - and that is a bottom.
For most companies, the majority of stockholders are predominantly "permanent" investors in the company's business. They're not in there to speculate, and they are not potential sellers in response to short-term fluctuations in the profitability of the business or of the stock price. Those who do respond to such stimuli are marginal in numbers. But on the outside looking in are a horde of potential buyers. When they lose interest, the result is a dry up in actual buying.
Let me end with a shocking contention: Supply versus demand does not always play a significant role in the price movement of stocks. There is another phenomenon, which, oh so many years ago, I gave a name to. I call it "spontaneous adjustment." The best example of this is an x-dividend adjustment. It is automatic because of a tacit agreement by all parties that the stock is now worth less, specifically by an amount equal to the dividend to be paid. Any time a stock becomes worth less or more in an undisputable amount (as in a merger, for example) a "spontaneous adjustment" takes place. And, many price moves are almost automatic, and take place through a combination of "spontaneous adjustment" and "supply versus demand."
As to your second question, can short-sellers alone cause the stock of a large company to fall? I'm inclined to think the answer is no, but I suppose it's possible for a limited period of time, particularly since hedge funds have become such a big force in the market. But remember, every short seller has to eventually buy that stock back, which means he may inadvertently become a potent source of demand.
We have some hedge-fund operators out there. Maybe one of them will volunteer an answer to this question. -DW
Don,
Short-sellers alone can't cause the stock of a large company to fall any more than long-buyers alone can make it go up. Anyone that assumes asymmetry between long-buyers/short-coverers and short-sellers/long-sellers has spent too much time on the Yahoo message boards trying to "get shorty". Or easier yet, let me ask your readers the question another way: which is more likely to make a large company stock fall...Fidelity selling long 5mil shares of stock, or XYZ Hedge Partners selling short 5mil shares of stock...or easier still, which seller will require an uptick? Regards,
Sean, CFA
[Editor's Note: The above memo came in response to our request for a hedge-fund strategist to explain whether short-sales alone could cause the stock of a large company to fall. For those who aren't familiar with the "uptick rule," short sales can be executed only on or following an uptick. ETFs are exempt from the rule. And, of course, the selling of shares from an ordinary long position is not bound by any such rule. -DW]
Don,
I have never failed to be astonished that anyone can believe the "more sellers than buyers" fallacy, and I am glad to read your de-bunk.
However, the Worden report did not mention the role of the Market Maker, who actually is the buyer and the seller. We all deal with him, so why is he so seldom mentioned when this subject is raised?
The Market Maker sets the price at the level which he expects will produce maximum volume. It only needs the MM and one retail trader to do business. The MM has the ability to balance his books by laying off the risk of the long or short position in the few seconds which follow the trade.
A study of gaps confirms the truth: When a gap event occurs, the MMs will often gap the price to an extreme, and then sweep the price across the gap to take the trades of all those who have been stimulated to deal by the gap, like trout jumping at an emerging fly.
Some time ago, I studied the London closing auction. A retail trader can post a buy or sell order with the price at which he is willing to deal, and may or may not be filled. After the closing bell, the MMs match bargains. Here at last in after hours trading, we have a situation which needs both a buyer and seller.
Regards,
John (Sir Limey - submissions on Ap 6 2001 and Ap 5 2002)
[Enjoyed your observations, John, but I doubt that that here MMs can arbitrarily induce a gap opening. Gaps can only be justified by significant imbalances in supply and demand. I have heard about "Mad Dogs and Englishmen," but I didn't know it extended to MMs. - DW]
Hi Mr. Worden,
I enjoy reading your Daily Worden Reports. Thank you for sharing your wise insights into the markets.
I also enjoyed reading Wednesday's submission by Sir Nine-Steps. Clearly he is a good investor. I particularly liked his reference to the 8% stop loss he uses based on a stock's hi-closing price. I have been thinking about using trailing stop-loss orders as well, but have been uncertain as to what percentage to set the stop-loss.
This weekend I am going to do some back-testing on my previous trades etc to see if this percentage would have worked well for me as well.
Thanks again for your keen insight and terrific software.
Sincerely,
Ray (Sir RWPOD, knighted on 3/17/06)
Sir Nine-Steps uses a volatility adjustment to control position sizing. I edited it out of his otherwise excellent submission, because it was too difficult to understand and would probably have caused confusion. Keep in mind that, if you are going to use a set percentage loss-cut, you should increase the percentage for volatile stocks and proportionately decrease the percentage for low volatility stocks. (You would have to develop a formula for that.) Otherwise you will frequently be stopped out of volatile stocks prematurely and out of low volatility stocks too late for optimum results.
Frankly, I think you will do better using the loss-cut system I publish from time to time. It is based on progressively protecting growing profits. I believe it was last published in the Worden Report of March 28, 2005. - DW
