Trading Bubbles and Panics

Greed can push prices far above any reasonable fundamental valuation. Fear can take prices lower than investors would have thought possible.

Trend traders make money in the markets not because they predict anything but because they buy what is going up and they sell what is going down. They discover ways to measure and react to trends based on historical price data and current price action. Trend traders identify a signal and enter a trade with predefined risk for the trade and make a plan on how to exit based on the capital at risk per trade and a price level that will tell them that they were wrong. Their goal is to be on the right side of huge market trends that are outside the standard bell curve of possibilities. When stubborn traders blow up because they have stubbornly bet on the wrong side of the market the trend trader wants to be on the other side of their trade. When a big trader or fund is in a position that moves against them day after day, week and week, and they are praying for a bounce or reversal in their losing position the trend trader wants to be on the other side of them.

The trends that blew up Long Term Capital Management, Amaranth, and Baring Bank had trend traders on the other side of the trades. What destroyed some traders made other rich, where do you think all that money went that they lost? Their losses went to the people on the other side of their trades. Bubbles and panics are caused by fear and greed running in one direction for an extended period of time. If a commodity starts to lock limit up or limit down day after day you should know there is a trend trader making money somewhere while other traders are praying for a reversal. Trend traders make their biggest profits when they are on the right side of a bubble or a crash.

What causes a “bubble”? Whether it is tulips in Holland, the South Sea Bubble in Great Britain, or the Dot Com bubble or housing bubble in the United States the principles stay the same. Investors and traders have capital that they want to put to work, they choose to buy what they think will appreciate in value. As more and more capital flows into an asset it goes up in value as more outside money wants in to a limited supply of a commodity, stock, house, or tulip. Markets go up for only one reason: that the current seller is not willing to sell for the current market price and the buyer is willing to pay more. Market prices move up because sellers will not sell for the current price and buyers are willing to pay more to get in.

The financial markets are an auction that work through asks and bids to buy and sell it is not a retail store where management sets the prices for everyone, supply and demand make price discovery happen on every trade. Many times a bubble will start when future expectations start being priced into a current market. As expectations rise prices can also rise for no real fundamental reason. When prices reach all time highs there is no real selling pressure because everyone is holding for a profit. The only thing that can slow down the price advance is profit taking as no stop losses are getting hit as higher highs in price are made. As long as new buyers are willing to buy at higher prices the bubble will continue to inflate. Trend traders don’t care why; they are just along for the ride.

Bubbles have everything to do with the holders and new buyers expectations of making money in the future not fundamentals. The reason people buy into a market bubble is that they believe they will be able to sell it for a higher price later. Bubbles are bought into and are driven up on the belief of higher prices in the future. Outside of commodity and option hedgers the only reason people buy is for a later profit. When the belief of a later profit ends so does the bubble and rising prices as the market runs out of new buyers at the elevated prices. The selling starts slowly but escalates as stop losses and trailing stops are hit first then profit taking panic slowly sets in. Euphoria is the fuel of bubbles.

The flip side of the bubble is the market crash. Fear and panic are the drivers of downtrends that overshoot low prices that people didn’t think were even possible. When the stock market starts going down fast, investors are not pulling up balance sheets and figuring out what should be a company’s stock valuation, they are selling their holdings after losing a lot of money. During panics price declines accelerate due to people’s fear of losing even more money. The downtrends are caused by individual investors making the personal decision to sell not after carefully study of the macro economic situation but because they want to stop losing money. Trend traders do not care why a market is down they are selling it short because the price action tells them to.

Many traders and investors are unable to make a lot of money in a bubble because they will sell short believing that prices will have to revert to the mean in price. Many also can’t buy into a bubble because the market is too expensive based on fundamental valuations. Other investors and traders lose a lot of money during market crashes because they try to buy a dip in price and all they end up accomplishing is being trapped in at higher prices as market prices continue to plunge. During downtrends many investors will give back the bulk of their bull market profits as stocks as an asset class simply go into distribution. Investors must have an exit strategy to lock in bubble profits before they burst and also not hold long positions during bear markets.

Fundamental valuations are useless during bubbles and panics while simple trend trading systems can capture big profits by putting you on the right side of the move in either direction. Trend traders have an edge during bubbles and panics because they do not need to know why a move is happening they just need a trend to happen they have the tools to capture it. Trend traders to not care about the direction or size of a trend they just want one.

“The whole world is simply nothing more than a flow chart for capital.” – Paul Tudor Jones

Trend trading tips:

·         Don’t sell a market short because you think it just can’t go higher.

·         Don’t buy a market just because you think it just can’t go lower.

·         Trade systems designed to maximize trend profits by not having price profit targets.

·         Exit a winning trade because the trend is bending.

·         Let your winners run until there is a reason to exit the trade.