Who's Selling When You're Buying? Know Your Trading Competition

The essence of effective trading is understanding what is causing a stock to move. If you understand the dynamics at work, then you can craft a strategy to profit from the movement.

In the short term, there is a lot of meaningless volatility that is created primarily by things that have nothing to do with the merits of the stock. Any stock that is in an ETF or index will be bought and sold when those vehicles are traded. That is often the main source of movement, and it has absolutely nothing to do with the valuation of the stock. This sort of action can create great opportunities, but to take advantage, you have to have to navigate market conditions and have the timing right.

Another major source of price movement is big funds that are adjusting portfolios. They may need to sell equities and move into more bonds or load up on big-cap technology and sell biotechnology. They move big baskets of stocks, and it doesn’t matter if your precious jewel is in that basket. If the name you are following is in the wrong sector, then it may be sold regardless of how great of an investment it might be.

 The Emotions That Drive Short-Term Traders

It is very important to understand these macro factors that are jerking a stock around, but if you are an active short-term trader, then you also need to focus on the emotions that drive other short-term traders.

A large number of traders look to day-trade stocks with very high levels of volatility. The main goal is to try to guess how far momentum might carry things and there is always a big group of traders looking to short these moves because they are often not justified on a fundamental basis.

If you are trading short-term, it can be extremely helpful to ask yourself, “Who is on the other side of this trade”? Traders often lose sight of this as they are so focused on what they believe are great fundamentals that they can’t even understand why someone would sell the stock.

The thinking is that anyone who is selling this stock is a fool who doesn’t understand its value. That is an incorrect assumption. There are plenty of reasons to sell a stock, even if it is a fantastic value that may go much higher over time.

A good example I saw on Friday morning was a very small stock that I had been following for a while. Sensus Healthcare SRTS sells equipment that uses image-guided superficial radiation to treat sun cancer and other skin issues. The company substantially exceeded revenue and earnings estimates and was trading higher Friday  on a giant surge in volume.

I believe the stock deserves a much higher valuation, so why were all these people selling when it was up ‘only’ 30% on Friday morning? Many are position traders that held into the news and are now happy to take sizable profits. They want to book that gain and aren’t concerned about it going higher. Most of the people trading the stock really have no idea of its valuation, balance sheet, or what products it is selling.

Many traders are involved simply because of the high level of volatility. Some have superficial knowledge of the fundamentals, but most don’t and don’t really care. Many of them are penny flippers that will try to capture moves of a few cents. There will also be some shorts that will try to capture shifts in intraday emotions.

Bigger, professional buyers are going to be very patient. Many will wait for the action to cool off before they move. They don’t like to chase strength, but it will become evident when they start providing support. These folks will be pullbacks and won’t chase strength.

More Trading Basics

• The Most Important Thing I've Learned in 25 Years of Trading
• Day Trading Is Very Difficult: Here Are 6 Tips for Long-Term Success
• Most Day Traders Fail. Here’s Why and What to Do About It

The Folks Selling When I’m Buying Aren’t Dumb 

My personal view is that the stock is a good value that can move meaningfully higher over time. So, my strategy is to try to position as the volatility traders move it around. The folks that are selling when I’m buying aren’t dumb. They just have a different focus than I do.

News and fundamentals are never inherently good or bad. Their impact depends on context and the emotions of those who are trading the stocks. ‘Bad’ news may see a positive reaction, and ‘good’ news may see a negative reaction depending on the situation.

In the long term, valuation, market conditions, and the economy will drive the movement in a stock, but in the short term, it is mainly about emotions. If you understand the emotions and have some sense of valuation, then you have conditions for a great opportunity.

At the time of publication, James "Rev Shark" DePorre was long SRTS.