Wednesday, October 28, 2009

Idiot Trades and Trending Markets

In this post, I'll define what I call "idiot trades" and then I'll define trending markets.

An idiot trade is one that occurs in a market that has already made a healthy directional move. As the market is further moving to new highs or lows, the idiot trade chases the movement with large size transacted at the market. Thus, it's hitting bids into market weakness or lifting offers into strength. The trade is sized up, so that the trader is basically going "all in".

The reason it's an idiot trade is that, most often, it's a capitulation. The trade is made either out of panic (can't stand the heat and ignored earlier stop levels) or out of a fear of missing "the big one". The key to an idiot trade is that it is made more for psychological than logical reasons.

Make sense? We've all placed idiot trades. They make us feel like idiots when the market, having made its healthy move, then makes a normal retracement, leaving us under water with good size on or just leaving us with the bitter feeling that we sold the low tick or bought the high one.

What makes it worse is that sometimes we *know* we're making an idiot trade even as we're executing it. My worst exits have been idiot trades, where I'm getting out simply because I'm afraid of giving back a profit or losing a larger amount of money. The idiot trade is made to seek relief, not necessarily to maximize reward relative to risk.

So what's a trending market?

It's one that ultimately does not punish idiot trades.

If you watch trades come into the market at key price levels (Market Delta is good for this), you can see the idiot trades and sometimes you can see herds of idiot traders acting in concert.

How the market ultimately treats those positions tells you quite a bit about whether we're in trending or range bound conditions.