I have had a record number of people reach out to me asking for coaching help. Why? The majority have developed their trading in a bull market and have learned to buy market dips. And so they have bought, and bought, and bought--and they have lost a lot of money in the past month. In my view, this is not a problem of psychology. It is a problem of not knowing how markets behave under different conditions of volatility, correlation, and monetary/fiscal environment.
As you may have noticed from my recent post, I am quite the optimist and believe in the power of making fresh starts--in life and in markets. To continue risk taking without knowing what you are doing, however, is not a formula for optimism. We have to learn from our experience before we can benefit from it.
So let's begin with two basic concepts of financial returns: the average return over a period of time and the variability of those returns over that same period. Too often, traders focus on the first and neglect the second.
Here's a current example from my database:
As of Friday's close, we had fewer than 20% of all stocks in the SPX close above their 3, 5, 10, and 20-day moving averages. That is unusually weak short- and medium-term breadth. Indeed, since the start of my database in 2006 (approximately 3900 trading days), only 179 days have met those criteria. In other words, the market is not only broadly oversold, but more oversold than on 95% of all occasions. Right away, that tells us that this is not just a normal market pullback, but something more extreme. But of course we only know that if we make the effort or invest the resources to create such a database. There is certainly no guarantee that the future will mirror the past, but pursuing the future with ignorance of the past is not a winning proposition in any field.
So let's take a look at the 179 occasions when we've been broadly oversold at these intervals and see what the SPX has done afterward. Sure enough, we find that the market, on average has been up +.75% compared to an average gain of only +.18% for the remainder of all occasions. Surely, therefore, we are due for a bounce and should be long going into next week! That is what I've been hearing from traders of late.
If we look a bit deeper, we find that the market rises after such oversold conditions 64% of the time, compared with 60% of the time for the other occasions. That doesn't look like such a great edge. When we look at the variability of returns, however, we see that the standard deviation of next five-day returns for the oversold occasions is more than twice that than for the rest of the sample (4.81 vs. 2.32). What does this mean? It means that, following such oversold markets, we have had significantly more volatile returns going forward. So, for example, in August of 2011, we would have made well over 7% over the next five trading days. In November of 2008, we would have made over 19%; in March of 2020, we would have made over 16%. But in October of 2008, we would have lost almost 19% over that next five-day period. In early March of 2020, we would have lost over 13%; in early August of 2011, we would have lost over 13%.
The important point here is that we have to be aware of the range of possible returns and not just the average return if we are to place intelligent bets.
Suppose I told you that I would make you a bet where you had 80% odds of winning $10,000. Would you take that bet? A not-so-smart trader would say, "Sign me up!" The risk-savvy trader would ask, "What happens the other 20% of the time?". Well, in this case, the bet is to go to an interstate highway at 2 AM and cross all lanes blindfolded with earplugs. At that time of the morning, you'd have an 80% chance of reaching the other side free and clear. The other times, you'd be hit by an oncoming vehicle and either crippled or killed.
Not such a great bet after all.
"We're due for a bounce" is not a substitute for a rational assessment of markets and their possible outcomes. No amount of trading psychology techniques can substitute for knowing what you're doing when you put capital at risk. People who tout their "passion for trading" most often need to trade and that leads them to take undue risk. Far better to have a passion for good bets. If you know that broadly oversold markets move a lot on average, the smart bet is to shorten your time frame, reduce the volatility of your returns, and find short-term bets that pay well without a scary downside.
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