Friday, February 13, 2009

Think Like the Herd, But Don't Follow the Herd

One of the most common trading problems I'm hearing about in 2009 is losing money by jumping aboard market moves (or adding to positions once they go their way) and then getting caught in reversals. We can think of markets as being either volatile or non-volatile and either trending or non-trending. In many ways, the most difficult trading environments are volatile and non-trending, because the moves can be sharp and yet won't follow through over the next time frame.

As I write this, we are trading at almost exactly the same price in the S&P 500 Index (SPY) as we traded on October 27, 2008. That is several months of going nowhere. During that time, however, intraday movement has been considerable, with a median daily high-low range of 3.8%. While this environment poses potential opportunity for nimble daytraders, it has proven challenging for those who hope to identify and ride short-term trends.

A key challenge for developing traders is learning to not overweight recent price movement in anticipating future movement. Just because a market is up during the overnight session doesn't necessarily mean that there is a bullish edge from open to close. Simply because the market is down over the last few days doesn't provide an edge for selling over the following several days.

It is human nature to fall prey to recency effects: what happened last often most stands out in our minds. We see a short term pattern of bars on a chart or a trendline, and our inclination is to see those extending into the future. With so many market participants trading at intraday and swing time frames--and managing their longer-term trades with shorter-term adjustments--by the time the market has moved in one direction for several days, the majority of players are already on board and leaning for further movement. When the market fails to go their way, they have to unwind their positions, adding to the reversal movement.

A big part of short-term trading success is recognizing when players are overloaded in one direction and about to reverse positions.

As a little exercise, I took a look at SPY when the market was up or down over 1% from the open two days ago to today's open. I call that the market context. I then examined what happened when the market was up from open to close following a bullish market context (up over 1% from the open two days ago to today's open) and when the market was down from open to close following a bearish market context.

Since 2000, when we had a rising day session following two days of good gains, the next five days in SPY averaged a loss of -.56% (113 up, 128 down). Conversely, when we had a falling day session following two days of good losses, the next five days in SPY averaged a gain of .46% (135 up, 103 down).

Particularly at short time frames, so much of trading success is being able to think like the herd, but act counter to the herd.