Monday, November 12, 2012

The Trader's mind V - The anchor

Humans do not actually have any ability to measure intrinsic value of any item. Practically all estimated values are fuzzily calculated from any claims of value the person may have encountered.

For example, if I show an object never seen before and ask what the value could be, people are likely to go blank. When pressed further, they may guess based on its size, weight, shininess and beauty.

You may have grandparents that long for the good old days when coffee was 5 cents a cup. The entire notion of paying $5 at starbucks seems absurd to them. And to actually line up to pay that ridiculous amount is quite insane in their opinion. This because your grandpa's valuation circuitry is stuck in the 1950s. A similar thing happens to all of us on smaller timescales. This is called anchoring.

When you see an item (say a pound of coffee) for sale at $5, you expect it to remain at $5. If suddenly it jumps to $10, you wont buy it right then, you wait for prices to come back down. But if the price remains at $10 for a few months, you are likely to give in and buy it for $10. Your mind is now anchored to the new price.

Anchoring is subtly employed by stores all the time. The 50% sale tells us that the fancy hat at $200 is cheap because its real value is $400. We are so lucky to get it half-off. Why, its like we just earned $200. All we have to do to earn it is to spend $200. The store has subtly anchored the value of the article to $400 in your mind. If there was no sale, you wouldn't buy it because $200 would look expensive. This is why when JC Penny decided to forego sales in favor of everyday low prices, they took a huge loss. Nobody has any reason to buy because nothing looks cheap.

Anchoring is what makes markets stay in trading ranges (coffee should be $5) and trend ($10 is the new normal). Anchoring is also why pullbacks, especially deep pullbacks work very well (50% off sale). In fact, anchoring is why price action works very well in general.

For a trader, this means that he can simply imagine he's either a seller of buyer of a pound of coffee or any other item that he is familiar with and correctly guess the behavior of the crowd most of the time. If the price gets too high or too low suddenly, there will be resistance and the price will pullback. However, if it stays there for a long enough duration, it can become the new normal. Deep and sharp pullbacks are more likely to continue and slow slides are likely to eventually break a trend for this very reason.

Once you can understand how price moves, you will find price action far easier to read and understand.

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