It never fails.
The more the stock market rallies, the more that traders focus on reward instead of risk.
It almost has to work that way. After all, as the stock market moves higher and higher without even a slight pullback, there are fewer and fewer low-risk trades. So anybody who wants to participate needs to ignore the potential risks of overbought conditions and just buy stocks – trusting that the bullish momentum will continue.
That’s been a profitable strategy so far in 2018. The S&P 500 is up 94 points in just eight trading days. That’s remarkable. We haven’t seen this strong a start to any year since 1987.
Of course, those of us seasoned enough to remember don’t recall 1987 as the year the stock market posted huge gains in January.
We remember it for the crash in October.
Now, I’m not suggesting that 2018 will play out like 1987. Though there are lots of similarities, it’s still way too early to draw that conclusion. I’ll discuss those similarities if they hold up over the weeks and months to come.
But here’s my point…
Everyone wants to participate in a rising market. It’s hard to sit on the sidelines and watch as just about everyone else is profiting. The pressure is too great.
So, we forget about the overbought conditions. We ignore the possibility that the proverbial rubber band is quite stretched and vulnerable to a snap back. And we buy.
That is almost always a mistake. Sometimes it takes longer than we might want it to, but the rubber band just about always snaps back.
That’s why folks paid $20,000 for a bitcoin (BTC) in December – even though the price had increased 100% in two weeks. I’m not saying BTC won’t be higher a few months or a few years from now. I don’t follow the asset closely enough to comment intelligently on it. What I do know, though, is the risk/reward setup is MUCH better after a 30% decline than after a 100% rise.
Declines are healthy. They relieve the selling pressure. They shake out the “weaker hands” and create a stronger foundation for longer-term gains.
Any asset that goes too far without a selloff is likely to get pummeled at the first sign of weakness. Everyone who’s anxious to sell – but didn’t do so for fear of missing out on even bigger gains – rushes for the exits. The rapid decline scares away the folks who would normally be willing to buy. And the price hits an air pocket.
That’s when you get a dramatic overnight decline.
If you have cash, then you can take advantage of the move and buy at depressed prices while everyone else is selling.
On the other hand, if you joined the crowd and chased prices higher into overbought conditions, then you’re more likely to be caught in the downdraft… and end up taking a loss on the trade.
In a nutshell, that’s the difference between “momentum” traders and “mean reversion” traders.
I wrote about these two trading philosophies a few weeks ago. Please review that essay. I suspect it will prove to be quite valuable in 2018.
Having said all of that, since it’s Friday – which is normally a mailbag day – I’d like to share with you a couple of emails I received from a frustrated subscriber to my Delta Report trading service. Here’s the first email I got in early December as I told subscribers to look for a big rally in gold stocks…
Can you PLEASE find another sector other than gold stocks? We’re getting killed in them.
ABX down hugely; GDX down; GG down. And today, to add insult to injury, CANE – obviously not a gold stock, but a painful loss nonetheless – has been a disaster.
While the market races up, you’re stubbornly playing the contrarian and we’re getting killed. If we had only been playing with these manipulated markets instead of against them (witness the SPY put), we’d probably be way up. Instead, my trading accounts are down in large part to your analyses and your picks. C’mon, you know the markets are rigged. Don’t bet against the FED!
Please find another sector other than gold (way too manipulated) and please make at least one bet with the market.
– David C.
I did not respond to this email. Instead, I took it as confirmation that I was right to recommend multiple trades in the gold sector.
This email is highly emotional. David writes about getting “killed” in positions like ABX, GDX, and GG. He wrote about taking a loss in CANE – which we did to the tune of -21%. But, if he’s been with me since I recommended that trade last April, then he’s had many more profitable positions.
Indeed, it was David’s email that motivated me to write the essay I published on December 19: “How I Know We Have a Winning Trade.”
I mean no disrespect to David. On the contrary, I understand his position. It is really difficult to stand on the sidelines – or even worse, buy into the most hated sector in the market – when everything else is moving higher.
So, I didn’t publish his email – though I share almost all of the negative stuff I get.
Instead, I expected that as the gold stock rally played out, David might see the rationale to my thought process.
My expectations were too high. Here’s the email I got this week…
Why are you fighting the Fed? I thought that was an axiom that seasoned traders followed. Whatever manipulation the Fed has been using (pinning down the low end of the curve, dark pools, whatever) it has kept the market defying logic, inducing irrational exuberance and causing (multiple) losses for your picks.
Obviously the COF put has been a disaster (I would happily eat my words if suddenly the banking sector tanks). Gold was supposed to rally (hopefully it will) but ABX has hurt us. GG did OK, and some of the other picks, but not enough to overcome the losers.
Can you ponder this over the weekend: Why fight the Fed? Can’t we have just one pick that rides this (seemingly unstoppable, Fed-induced) rally?
– David C.
David, thank you so much for your email. I totally understand your frustration and I hope my response can shed some light on my thinking.
I’m a “mean reversion” trader. I view the broad stock market like a rubber band. I hope that it stretches too far in one direction so that I can profit as it snaps back to normal conditions. Those are the types of conditions and the types of trades I look for.
2017 was a momentum market. It was a freight train that only moved in the bullish direction. Momentum traders should have made huge gains. Even so, those of us who trade on the “rubber band principle” still had a few opportunities to profit.
Since you were with me on my CANE recommendation – which was last April – I’m assuming you’ve been with me on every trade since then. If so, then you’ve had plenty of chances to profit.
2017 was a HUGE year for momentum traders. The S&P 500 didn’t pull back even 3% for the whole year. So the wind was at their backs.
Those of us who trade based on the mean reversion philosophy had a tougher time. Even so, we had a huge year in the Delta Report. We were profitable on 79% of the trades I recommended in 2017. The annualized return on those trades was over 200%.
And those returns are based on a philosophy that was out of favor last year.
Going into 2018, there are very few sectors that offer lower-risk opportunities to profit. The ONLY sector that looks good to me is precious metals. It’s had a good run higher over the past month. But the sector is so depressed, I think there are much larger gains ahead.
You can argue. You can say that I ought to focus on momentum rather than value. But that’s not my style.
If the stock market keeps pressing higher, then I’m going to keep looking for trades that offer low risk and high reward. If those trades don’t exist, then I’ll tell folks to sit on the sidelines.
I’m happy to underperform the market in the short term. I know the market ALWAYS reverts to the mean. And I’m okay sacrificing short-term gains for the risk of intermediate-term declines.
David… if you want a more aggressive option trading service, then there is no shortage of choices available to you.
I suspect, though, you’ll have a tough time finding one that racked up the track record we did in 2017.
Even though it wasn’t an ideal market for a mean reversion strategy, we found a few opportunities that produced stellar returns while taking on low risk.
Asking me to shift my focus to momentum trading is like asking a cat to bark like a dog.
It’s unnatural. It’s not going to happen. Cats don’t bark.
2017 was a big market for momentum traders. The stock market enjoyed a one-way move higher. That move has continued into 2018. So, momentum traders are having a great time.
Even so, my subscribers did really well in 2017 despite sticking to a strategy that was out of favor.
So far in 2018, we are underperforming the broad stock market indexes. And I’ll take whatever criticism you want to throw at me for that.
But good heavens… we’re only eight trading days into the new year.
The portfolio I’ve recommended is HUGELY slanted towards a rally in precious metals. Almost nobody else supports this position. So I’m sticking my neck out and betting on the rubber band snapping back.
This is the best-looking low-risk/high-reward trade I see in the market right now. The downside to buying mining stocks is minimal while the potential reward is quite substantial. Only time will tell if I’m right or wrong.
But there’s one thing of which I’m certain… If I’m right, my subscribers will see huge profits. If I’m wrong, then the downside should be minimal.
That’s the epitome of a low-risk/high-reward trade. And, that’s the only bet I’ll make in the current market environment. More importantly… it’s the only trade I would recommend for you to make in this situation.
I’m going to stay focused on the risk. You may not agree with it. But since you subscribe to my service, you’re entitled to my best advice.
I’m not buying anything else today except precious metals stocks. It’s the only sector that looks like a low-risk/high-reward trade.
Best regards and good trading,
Is your trading style based more on momentum or reversion? What approach do you think will be more successful in 2018?
As always, feel free to send in your trading stories, questions, and suggestions right here.