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Mike Baghdady Headshot

Human Behaviour can create trading opportunities.

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The current climate of uncertainty on the financial markets has held grip since late 2007 and was formally recognised in 2008 when Lehmann Bros went under. How much of the current climate is fear-driven? Does this mean that recessions wouldn't be as hurtful to people's pockets and the overall economy as they are if the emotion of fear was taken out of trading?

There is an old saying in the City that says that shares go up by the stairs and come down by the elevator. Look at any chart and you will the price will slowly and steadily rise and the moves down tend to be significant and can wipe out months of upward movement in days. This is because people sell their investments in a panic. It's human nature. It's also human nature to be cautious and to spend time researching where you should invest your money beforehand, but once the price starts to go down, fear sets in. Fear creates a panic and the price drops considerably. In the last decade, the FTSE100 had four uninterrupted up years between 2003 and 2007. Those four years of solid gains were virtually wiped out in 18 months until the low of the market in 2009.

I can trade the markets as they go up and as they go down. Fear creates opportunities to the downside and these happen faster than the upside. To break it down to its most visceral level - fear pays better than faith in the markets. It's a horrible fact, but it's true. Everyone got caught up in the housing market increase and properties were bought above their asking prices and bidding wars ensued. This is emotion in the market forcing prices up as people are confident and optimistic enough to buy, often at any cost. The inverse happens when a market is declining as people rushing to the doors to get out, making the market drop dramatically.

Trading is about psychology more than it is about choosing the right stocks to invest in. Trading is an approach and a mindset, it's NOT about predicting the future. When it comes to selling in a declining market, people want to get out quickly and the fear is removed. Knowing how human beings behave is vital as we need to understand that behaviour to be able to trade in the market. There is a line in the movie Trading Places where Eddie Murphy's character, having been taken off the streets and turned into a trader that explains it perfectly. 'Pork belly prices have been dropping all morning, which means that everybody is waiting for it to hit rock bottom, so they can buy cheap and go long. Which means that the people who own the pork belly contracts are going bats**t, they're thinking, "Hey, we're losing all our damn money, and Christmas is around the corner, and I ain't gonna have no money to buy my son the G.I. Joe with the kung-fu grip!" So they're panicking right now, they're screaming "SELL! SELL!" 'cos they don't wanna lose all their money, right? They're panicking out there right now.'

Once the market is in a state of fear and panic sets in, the price drops dramatically, investment diminishes and, eventually, the country will probably slide into a recession. If the value of everyone's investments have gone down, as well as our houses, then we don't feel as confident about the outlook. If we're uncertain, we're less likely to employ people at work, to go on holiday or buy the odd luxury gift, Suddenly, after four years of unstoppable growth, it's all gone in 18 months if you're the FTSE.

It takes a very long time for the sentiment of the population to change from fear to faith but less so from faith to fear. It is possible to make money out of declining markets, but it sorts out the good traders from the bad ones. The bad ones refuse to believe or see what is going on around them, blinded by their own beliefs and end up losing inconceivable amounts of money. Just ask the bosses at Northern Rock, RBS, UBS etc. We have gone from a time where credit was given out free and easily to the point where credit is hard to come by. Even the banks are refusing to lend to each other, never mind to small businesses that could help boost the economy.

The Greek economic situation is parlous but people are only looking seriously at the problem now, but it's been in the news for many months. In the free and easy days of credit, no-one would have bothered asking the salient questions, never mind giving the finances of states a thorough examination. There is an element of foreboding regarding Ireland, Spain, Portugal and Italy too. Will sovereign level finances across the board prove to be a collection of bare cupboards with nothing left for us? Governments owe money to the banks and they need to repay their loans otherwise the interest rate at which they can borrow will go up if they're perceived to be a risk. It could cost us all a lot of money in the long run.

It's no wonder the man on the street feels under pressure and fearful. If the banks will no longer lend to countries or other banks, what chance do the rest of us have? Every day in the media there is a story about a bail-out, a rescue package, job losses, sovereign debt and defaults and this reinforces the population's depressed mental state.

Does this mean that fear is part of the system that goes into creating a recession? Partly. When people are pessimistic about the economy, they spend less and invest less. When people are optimistic, the opposite happens and everyone is happy - if a little carefree with their lending. It could be argued that the oversights and profligacy of the good times are what drags down the sentiment in the bad times as politicians and bankers all commit to learn from the mistakes of the past.

Time will tell how it all plays out, but the current climate is fear. It takes a very long time for sentiment and opinion to change so it's not about predicting when it will end, but accept it for what it is and trade accordingly. We are not predicting the future, we are trading what we see in the charts and the charts of the major stock indices show that fear is the primary group mentality. At some point, the markets will bottom out and then, after a period of consolidation, they will start to rise, slowly and steadily.

In the meantime, it might best to hold onto your hats and see which way the wind blows. It could be an icy blast.

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