To remain rational in an irrational market, is that rational?

I'm a right-side trader. I’m trying to illustrate why right-side trading is reasonable for me and how to use it.

I promise, this is a long but super interesting, informative, inspiring, and easy-understanding article. If you are interested, I recommend you all to read thoroughly this post and after that you will definitely have a deeper understanding about trading. If you can't read it all at once, I also recommend bookmarking it for next time!

The following part is divided into four sections
1. Introduction: Market could be irrational
2. Error can be self-fulfilling: NVDA stock split
3. Right-side trading: A way helps you get through irrational market
4. Find the trend & an example

Let’s get started.

Market behavior is composed of human behavior. Are humans rational? I don't think so.

Expecting humans to remain rational is too demanding. On one hand, it requires people to swiftly gather all market information; on the other, it demands that they process this information without bias.

As a result, FOMO frequently emerges in the market. Remember the last time you saw everyone investing in a hot stock, and you just had to jump in because you didn't want to miss out? That's FOMO.

I've experienced FOMO as well. During that time, I thought that others who were buying in might have better insider information than I did, then I chose to act on my FOMO.

So, I can totally understand and would not blame this kind of irrational behavior, and in fact, I believe no one can remain perfectly rational at all times and sometimes be irrational is a kind of rational choice.

However, once we acknowledge human irrationality, which in turn makes market behavior difficult to describe as rational, the question arises: if the market is irrational, should we maintain rationality and trade against the trend, or go with the flow and trade in the direction of the market? Just think about it.

The benefit of staying rational is that it helps us "do the right thing", hoping that the right outcomes will manifest in reality instead of the wrong ones. But is that really the case?

As a matter of fact, once a consensus is formed, even if it's based on a wrong premise, it can still become self-fulfilling. NVIDIA's stock split can be a great example.

Recently, I've seen numerous opinions, suggesting that the split will make NVIDIA's shares more affordable, enabling more people to buy them, thereby increasing demand and driving up the stock price. In other words, many people expect NVIDIA's stock price to rise because the upcoming stock split will make it more affordable for a larger number of investors. I've also seen some data showing that NVIDIA, Meta or other stock prices rose by xx% following their previous stock splits, trying to support this viewpoint.

Then, what's the reality of this situation? Since the stock split announcement, NVIDIA's stock price has surged by 42%. It appears that people's predictions about the stock's movement have been quite accurate.

However, it's worth noting that, this viewpoint is completely incorrect, according to the traditional financial asset pricing. The reasons are:

1. Asset prices are determined solely by the discounted value of their future cash flows. Roughly speaking, the price of NVIDIA's stock should be determined by its future performance. Does a stock split affect the company's future performance? Clearly, it does not.

2. Traditional finance theory suggests that when people choose to buy NVIDIA's stock, it can only be because the stock is undervalued. So, if a stock split becomes the reason for a price increase, it can only be because NVIDIA's stock was originally undervalued, and investors who could afford the stock were unable to invest enough to push the price to its rightful level. In this scenario, a stock split would indeed bring more capital into the market, helping NVIDIA's stock price rise further. But do you think this is possible? Investment banks certainly aren't short on cash. Then without cash constraints, NVIDIA's stock price would already be at its appropriate level, not undervalued. So, no money would come into the market, then what difference does a stock split make?

According to the theory, I should buy some put options or short NVDA directly, when I notice that NVDA is rising. Then, what's the outcome? All of you know it.

So, I'm not trying to show off my knowledge of finance. On the contrary, what I want to emphasize is this: I made a rational and seems like correct judgment about the stock price based on traditional finance theory, but reality proved me wrong — NVIDIA's stock rose by 40%.

This indicates only one thing: the market is not being driven by rationality at this moment. In other words, even if the reason they believe NVIDIA will rise is wrong, as long as that reason is widely known and accepted by the majority, forming a consensus, NVIDIA's stock will indeed go up.

In this context, let's revisit the question we just considered: Knowing that the market is moving in an irrational direction (as with NVIDIA's stock here), would you stay rational and avoid entering the market or even short the stock, or would you follow the market and buy in? My answer is, never go against the market, and don't try to predict its turning points and then short it.

Back to our main topic, LST vs. RST, the diagram above clearly illustrates the difference between the two approaches. The essence of left-side trading is about forecasting the market, trying to predict the turning points, with the goal of buying at the lowest and selling at the highest. On the other hand, right-side trading is about going with the flow of the market, buying when an upward trend is confirmed, and selling when that uptrend clearly comes to an end.

However, the issue is, as we just said, the market is often irrational. How can left-side traders use their rational thinking to predict the market's irrational movements? The NVIDIA example will keep happening to them.

Hence, I am a loyal right-side trader. I might occasionally predict the tops and bottoms of stocks, but I never base my trading decisions on these predictions. Only the establishment of a trend makes me trade stocks. The advantages of this approach are:

1. You don't have to bear the risk of failed predictions or invest excessive time. Left-side traders often have a strong belief in their so-called value investment judgments. When they think a stock is undervalued, they buy it and hold it, buy the dip, confident that the price will eventually go up.

I'm not saying this approach is wrong. From a long-term perspective, if the price is indeed undervalued, it will surely rise again. But the market is irrational—how long will it take for the price to rebound?

If a stock's downward trend hasn't definitively ended, the probability of it continuing to fall is higher than rising. Buying at this point means that unless you can accurately predict the turning point every time, you risk getting stuck in a long-term decline if you get it wrong even once. Why take such a risk? Knowing that the price is undervalued, you should keep patience, wait for the downward trend to end and the upward trend to establish, and then enter the market. I believe this is a better approach. There's absolutely no need to make predictions.

2. Once you become a right-side trader, you no longer need to worry about the "exit point" issue. For example, if you are a left-side trader and you buy a stock at $10, when it rises to $12, thinking it's peaked. But as the stock keeps rising, you regret selling and buy back at $13, then sell again at $15 out of fear. This cycle continues as you buy at $17 and sell at $20, only to buy again at $22. Eventually, the stock starts to decline, but you hesitate to sell at $21, $20, $19, and so on, ending up stuck with it. The issue is that left-side traders try to predict market peaks and sell, but the market is irrational and unpredictable.

As a right-side trader, our approach is to set a stop-loss. For example, if you buy a stock at $10, you set a stop-loss at $9. When the price rises to $12, you raise the stop-loss to $10.8. When it reaches $15, you adjust the stop-loss to $13.5, and so on. When the price hits $22, you increase the stop-loss to $19.8. If the price then starts to fall and approaches $20, you are prepared to sell if it drops below $19.8. (The specific stop-loss levels here depend on individual preferences and the trend)

3. Most importantly, right-side trading doesn't mean abandoning all rationality; you simply aim for your "rational level" to align with the market. Being too smart can make you get far ahead of the market and incur unnecessary losses, while being too slow can make you lag behind significantly, potentially becoming the one left holding the bag. So, staying in sync with the market and following its trends—doesn't that sound like a good strategy?

You can still do everything you would as a left-side trader, such as tracking a company's fundamental information and predicting stock price highs and lows. However, when trading stocks, remember to only trade when the trend is established. At this point, fundamental information can actually reinforce your trading confidence.

Always remember, in the short term, irrational behavior can often dominate the market, and in such a market, staying rational might not be the most rational choice. Keep patience, find the trend and follow it, you may find that trading becomes much simpler.

Now, the question is, how to find the trend. You need a lot of practice, but here's a tip you can refer to.

The relationship between volume and price is the most fundamental tool for observing stock price trends.
1. A rising stock price means demand exceeds supply, while a falling stock price means supply exceeds demand
2. An increase in trading volume indicates a divergence in market consensus, while a decrease in volume suggests the formation of market consensus

Why? First one is quite simple, and let me explain the second one in detail. Think about it: if everyone in the market believes that NVIDIA's stock is worth 100 units, and its current price is indeed 100 units, would there be any trading? There's no need for it. However, if half the market believes NVIDIA's stock should be worth 150 units, and the other half thinks it should only be 100 units, while the current price is 100 units, would there be trading? Clearly, there would be.

So, an increase in trading volume signifies a divergence in market consensus, and a decrease in volume indicates the formation of market consensus. Now, if we consider volume and price changes together, we can arrive at some interesting conclusions.
1. Rising/Falling/Sideways movement + Relatively low trading volume = The market has a certain degree of consensus, indicating the continuation of the rising/falling/sideways trend
2. Rising/Falling/Sideways movement + Relatively high trading volume = The market is starting to show divergence, and the trend may change

Although the stock price consolidated sideways for a few more days at this level, it consistently stayed above the EMA5, and soon after, it broke through the resistance level with increased volume, confirming the uptrend once more, and the stock price continued to rise.

This continued until a red candlestick with a long upper shadow appeared, and the trading volume that day was more than double that of the previous day. At this point, you need to be cautious about whether the uptrend is ending. Observing that this candlestick did not break below the support line, you could choose to close your position or continue holding.

Then, one day, the price broke below the support line on low volume; since we had not yet confirmed the start of a downtrend, this could be a false breakout. Indeed, the stock price continued to rise afterward.

Finally, we saw another high-volume top, followed by a series of high-volume declines, which basically confirmed the end of the uptrend, leading to the decision to close the position.

There are also many other indicators that can help us to identify the trend, like EMA/MA, MACD and RSI, but it's hard to share them all in one article. So, remember to /heart and follow me to get more profitable information! Leave a comment below if you have any questions and please let me know if this post is helpful.

Peace.