The toppy, choppy stock market looks like trouble to some. But short-term traders can profit in both up and down moves, as long as they know which trend—long or short-term—they are making friends with.
By Vikram Rangala
Monday, June 6, 2016
"The trend is your friend until it ends," is the old trading advice, but the trick is knowing when exactly is the end. The S&P 500 hit a new all-time high Monday with a number of sectors rising together. Materials, financials, health care, and utilities saw overall rallies. As often happens with a new high, many analysts immediately warned bullish investors that the stochastics were overbought, the moving averages looked toppy, and not enough companies are issuing IPOs or other new stock for purchase. So is this the end, or the beginning of a summer rally, or neither?
These are bearish signs, for sure, but a new high is still a sign of a long-term uptrend that is still up. That's not to say it won't go down in the short-term, as it did after the last all-time high in April. Picking the top and deciding to sell there is a game for two kinds of investors: the foolhardy (some would say foolish) and the rich. While Nadex never recommends trades, I can say that just deciding that a new high means it's time to short-sell is, well, shortsighted.
However, if you are a short-term trader, then you should plan on both days of selling and days of buying in the coming weeks. When the market is an active contest between bears and bulls, some days will be up, some will be down. Our job as traders is not to tell the market what it should be doing, but to listen and just go with the prevailing direction. Blend with the trend should be our motto in the coming weeks, whether it's an up day or week, or down.
We might add a third kind of trader to the above two: those who know they are rich enough they can afford to be foolhardy and thus place sloppy bets. They know they are likely to take huge drawdowns along the way, but they don't mind. Unfortunately, most of us don't have that luxury and it's unwise to try and trade the way they do.
For example, a trader I know took a large long position on crude oil futures in mid-2006. In fall, crude fell 20% and he was down about $25 million. This guy was one of the Market Wizards in Jack Schwager's classic book of that name and, having started with a small amount of money, was a self-made multimillionaire. In other words, he had some reason to think he knew what he was doing.
His broker told him to get out and regroup. All but a few were shaking their heads. A few jealous people gloated (which tells you something about why they didn't have as much money). He didn't get out. Instead, he bought a few racehorses (as one does during financial crises). Expensive thoroughbreds. And he bought even more crude contracts.
From what I understand, he never bothered to hedge his position with options, either. He just rode out the $25 million loss, rolling over his position, and then by mid-2008 liquidated for a $70 million profit.
Though his initial buy might have been premature, he had a plan for what to do if prices went even lower. He would buy more. Because he knew what trend he was trading. He was trading the long-term trend, which was up, and treating the short-term dip as just one chapter in a bigger story.
Short-term traders can take a lesson from that: know what trend you are trading. Is it the long-term move up or down, or the shorter-term swings along the way? Each one has its own rules. If you short the current market, have a plan for how you will exit if it retests or breaks Monday's high. And if you buy, plan for the dips along the way up.
Over a little more than a year's time, he risked $25 million for the chance to get $70 million. Does that sound like a trade you would make, even if you had an eight- or nine-figure net worth?
25 million is a lot of money for most people. But how would you feel about a trade in which you risked $25 for the chance to make $70? And in which you knew that $25 was the absolute most you could lose, guaranteed. That's what Nadex binary options and spreads offer you. Tremendous percentage returns (if a 180% return sounds tremendous to you) with guaranteed limited risk.
Even in the world of Market Wizards, most investors and traders would be happy to get back even $28 or $30 million on a $25 million investment. That's 10 to 20 percent. 25 to get 70 is rare in the investment world. But it's reasonable (though obviously not commonplace) in the world of binary options and spreads. So is 25 to get 30. Either way, you know up front that you're risking $25 per contract and no more.
From that secure foundation, it's much easier to think about double and triple digit gains, even if they're on a smaller scale. And of course, you can trade multiple contracts, hundreds at a time if you want, with the same guaranteed risk caps. It may not pay for a stable of thoroughbreds, but you know you won't ever buy the farm.
Photo: Thomas Hawk on flickr, CC
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