Does This Trade Feel Crazy Enough?

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  • on February 4th, 2011

If I were a trading educator, I’d start my class with the Seinfeld episode about doing the opposite. There’s a reason that doing what feels natural is not the best approach to markets; if it’s easy to do, it can’t work consistently.  The law of supply and demand says it just can’t…we’d all pile into the same idea and only the fastest could win.

Don’t get me wrong, I place great value on instinct and have a difficult time explaining exactly why some trades just seem right.  But instinct comes with experience…it’s impulse that is far more common and destructive.  So how about a checklist at our desk that keeps our lizard brains in check?

Well, popular investing axioms sound great, but they’re mostly useless.  “Buy when there’s blood in the streets” makes sense, but needs context.  Most of us have no problem buying fear…isn’t that a natural reaction when you feel like the world has lost its mind?  But we don’t want to buy fear; we want to buy panic, or more safely after panic when most are just relieved the pain has stopped.  Specifically, we want $BAC after a triple to 8 on the way up, not when it feels cheap at that price on the way down…HUGE difference.

“Don’t fight the trend” is another, but blindly joining a trend is a recipe for disaster.  You’ve entered purely on price momentum, and a pause in long-term momentum may look nasty in a shorter frame…just in time to “cut your losses”.  Following the trend is great advice for selection, but not without stalking a low risk entry.

Buying doubt is the best recipe for profits, and is the bridge to all successful styles.  Value and relative strength have proven to be the two most consistent ingredients to market success, because the psychology needed to execute them is so outside the norm.  “Buy low, sell high” is known to everyone on Main Street, but “low” doesn’t mean when a popular stock just starts its breakdown and seems cheap;  “high” shouldn’t be the early stage of a growth cycle when a stock has raced ahead and seems expensive.

We are in the ultimate “too high” market, because we’ve seen how low prices can go and naturally have a hard time paying higher prices for them.  But unlike profit margins and sentiment and valuation, stock prices and sales don’t mean revert.  Doubters are often just believers yet to be converted, and until volume explodes after a rally that moment of belief likely sits in the future.

In analyzing my trades, it’s painfully obvious that my losers felt much safer upon entry than did my winners.  LVS is a prime example of a stock that felt great as a short(loss) early in the year, and frightening as a long(gain) when bought at much higher prices.  I continue to see examples of trades passed because of the “danger”, but often that perception of danger is what makes it the right one to take.  Costanza had it right…don’t be afraid to make the hard trade.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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