This is the first of a series of 4 articles titled “Key Concepts to Correct Trading Behavior”. This series is introduced here.
The Bandwagon theory is an analogy that is so important for traders that it is well worth the time spent reading this series of articles. But it is important that the reader grasps all it contains. A truly understanding of the message and the hidden wisdom in this theory can create the conditions to reach true trading mastery (believe me!).
The theory provides an insight into the inner workings of the market and how the average trader is ‘manipulated’ for profit. In reality it would be honest to mention self-manipulation because consistent, professional traders and those ‘in the know’ cannot move the markets. But they can use information to position themselves that the average traders do not have. This is not about COT, secretive information or special indicators. It is about understanding that the psychology we bring into every day life activity is not useful, actually it is dis-useful for correct and consistent trading. They know it, but the average trader (and even the average market professional) does not know it or did not yet understand that it is the lack of a market-oriented psychology that affects trading results.
A transfer from the larger group of average traders and hedgers onto the smaller group of consistent professionals is what keeps the market moving. Without this the market would not be orderly and it would be impossible to stay in it in the long run. The whole game called trading is contained in and explained by the bandwagon theory that is offered below. It is important and beneficial for the trader to make no assumptions but to check for him/her-self and then maybe learn to believe that the following is the real truth about the markets.
I strongly encourage the reader to carefully study and think about the Bandwagon Theory. After all professional traders are not smarter individuals, they just know and understand the correct way to deceive the crowd and leverage on wide-spread weaknesses. Make your choice and decide which side you want to be on.
Before proceeding I want to remind the reader that the theory is an allegory, so it may be difficult to link it back to market price and its behavior in a straightforward way. For this reason, and to make it easier to understand, I will include in the eBook I am writing (based on this series of articles) annotations that will be used to illustrate the theory on the swings of a real market, the Euro-dollar FX futures contract (EUR/USD). This will allow easier access to the wisdom and ‘secrets’ hidden in the Bandwagon Theory.
Hereunder the Bandwagon Theory to read and study carefully:
“Imagine a bandwagon that is rolling forward at a quickened pace. Music that is very pleasing to the ear is being played from speakers on each side of this bandwagon, and a few people currently on the back of the wagon are partying, having the time of their lives. The music, loud and clear, starts to attract many other onlookers that happen to be idly standing on the sidelines. These onlookers, unable to resist the sweet sounds being played, run to join the party that seems to be going on.
Progressively, more and more onlookers jump on the back of this bandwagon, and those few who were initially enjoying the first phase of the party begin to leave. As the crowd of new party animals on this bandwagon grows larger, the bandwagon finds it harder and harder to move forward at the same pace. It slows, enabling more and more late onlookers, witnessing the great fun, the chance to jump on. The crowd grows even larger. Larger and larger this crowd grows, until the bandwagon, heavily laden with the bodies of drunken party animals, can no longer move forward. It finally comes to a complete stop. Now that the bandwagon is at a complete standstill, more people jump on. And why not? At this point, joining the fun is easy. Absolutely no work is required, for individuals wanting to join the crowd no longer have to run to jump on board.
The nature of the bandwagon is to move forward. Its motionless state is unnatural, and therefore cannot last. It tries to move forward again, but can’t. The crowd, piled on back, is much too large. It must free itself of the heavy burden. And it does. It quickly shifts into reverse, and jolts backward, knocking a few of the party animals off the back. The music stops. Puzzled faces from the crowd begin to emerge. Before anyone figures out what’s going on, another backward jerk takes place, only this one is more violent. Another large group of people gets thrown off the back. Now, reality sets in. The fun has turned into a nightmare of epic proportions, and panic begins to run rampant. Some decide to jump to their deaths. Another thrust backwards sends an even larger group of drunken, off balance people, hurling to the muddy ground. It doesn’t stop. The jolts backward continue, each successive one more violent than the last. At this point, only a few die-hard wagon dwellers are holding on, their very lives hanging in the balance by a very thin thread. Failing to be completely free, the bandwagon angrily puts the pedal to the metal, and this final thrust backward is so vicious that its front wheels lift high off the ground, momentarily suspending the wagon in a perpendicular position. The last of the hangers-on crash to the ground, broken and maimed to no end.
At this point, a new group of onlookers emerge from the nearby woods. They are clean and serene. Each movement they make is deliberate and powerfully energetic, for they did not take part in the tragedy that just transpired. Or did they? A few of the dejected souls lying on the ground take a closer look, a look that reveals something very interesting. This seemingly new group is not new at all. It is the same group that was seen quietly exiting the party before it came to its violent end. An even closer examination by a few more beaten-down onlookers reveals something even more stunning. This group not only exited the party early, they were the originators of it! “My God,” someone exclaims.
Paralyzed, and unable to move freely, all these dejected souls can do is watch, as the masters of the game go to work, again. No sooner does the bandwagon’s wheels hit the ground than this professional platoon bolts for the wagon. In a flash they are on board. Easy. The bandwagon, now free of the larger crowd, can move forward freely and gracefully, comfortably carrying the more astute group with it. Its pace quickens, and before long a smooth elegant stride is in place. After a few miles of uninterrupted movement, someone from this masterful group flips on a switch, and suddenly the loud sounds of entertaining music start again. Someone yells, “OK everyone. Here they come. Let’s do it again.” Within moments, those who were the former victims of the backward crash become interested again. The music almost calling them from the grave. And once more, the never-ending cycle repeats.”
The metaphor of the bandwagon is a compelling one. But what does it mean in practice? What should an average, non-professional trader be aware of? In order to show how the Bandwagon Theory works in practice two examples are provided in the following: the first one applying to investors; and the other relevant to intraday traders.
The first example it is set back in 2000. Weeks before the burst of the so-called technological bubble a lot of investors (and traders) were not able to recognize the current state of the market. Too often people were making bad trading decisions and getting bailed out by general performance of the irrational market. For instance, people buying overbought conditions in a very strong market were rewarded by prices continuing higher. However, that is something I would not consider a good trade, even if it made money, as it only reinforced bad behavior.
These people, who were not experienced investors or traders, just bought something and it went up. It did not matter what they bought, it went up. It did not matter they were chasing stocks at highs for less than $10 or $20 points, it went up. It did not matter that they did not have a method, position sizing or exit strategies: the market (the tide) and all stocks (the boats) went up. They may have believed they were great traders but many of them have not fared too well since the bubble burst and many have lost everything. These investors and traders joined the bandwagon at the exact wrong time, when the professional players had already left the stock market or were in the process of doing so. This scenario repeatedly occurs, for example during the 2007 top.
I know personally people who played the US stock markets in 1999 and 2000 (but probably most of us do). One of them did not have a method but would simply buy highs in a reactionary way. He ended up losing money, the equivalent of “a small car”, as he once confessed, a loss estimated in around €12,000 (or $15,000) in just a few months.
The second example relates to the bad but widespread behavior of buying highs after big green or white candles, and selling lows after big red or black candles. This happens in all timeframes. For instance, when people see a 15min green bar they assume “the market is going higher” and they buy highs. The market typically reverses and suddenly their position is in the red. As they have no plan, because this is a reactionary trade, i.e. simply a reaction to a green bar, they end up selling in pain.
This type of action, again, shows psychological weakness that prompts the trader to jump onto the bandwagon at the worst possible time. When professionals see a green bar they are either taking profits or not doing anything in expectation of even higher prices, if price is not in a profit taking area. Their actions are planned in advance and in detail. They wait for their price with limit orders and have well defined profit targets, so they do not act out of fear of losing a move or based on the shape and color of a bar.
In conclusion, these two example should show how widespread, among investors and traders, is the behavior of entering the market at the worst time, is in all timeframes. A common mistake is to use indicators to decide on market entry. In fact, very often the information provided by classic price-derived indicators will prompt the trader to enter at those very spots where he or she should, instead, remain calm and examine the situation more carefully.
When traders do jump on the bandwagon at the worst possible time, often without a trading plan, the outcome is always the same: they are pushed out of the wagon, which means they are pushed to close the position at a loss because it was in the red since the beginning and it ‘never worked’. The real reason is that that, even if the market idea was good, the trader entered at the wrong time. Becoming part of the realm of professionals – the elite 5% – as I call the group of participants consistently making money, requires a deep understanding of market psychology dynamics. If the trader succeeds he/she will be able to objectively manage those basic instincts and impulsive actions that make us act like the crowd.
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The second shorter part of this series will discuss the ‘Danger of asking Why’. Notice that the chapter ‘The Psychology of Trading: the Bandwagon Theory illustrated’ will only be included on my free eBook that will be available on the home page of this blog.
Author: Giuseppe Basile, September 27th 2012
 extracted from “Tools and Tactics for the Master Day Trader”, O. Olivez and G. Capra, Mc Graw Hill