For the most part, there is an inherent buy-side bias when it comes to financial markets. This occurs because of the fact that most people invest in retirement accounts by either purchasing mutual funds, or buying the shares of the companies they work for. Although allowed in some types of retirement accounts, trading in derivatives such as options or futures is very uncommon as most don’t have the know-how required and thus never trade these instruments.
This means that these buy-side only folks have a chance at positive returns only when the market is moving higher. So what can these investors expect when the market moves sideways or down? Well, in a downtrend (commonly known as bear market) this contingent suffers. They bide their time hoping for the next bull market to emerge, and when the market is range bound, dividends are the only returns to be had.
Having a strategy that profits in all market environments is of course critical for long-term success. Knowing when to change that bias is more challenging, however. Some traders have been conditioned not to have a bias as it may cloud their decision-making process. I don’t entirely agree with that assessment since timing the market requires that a trader take a directional bias. This is what we can call our strategic bias.
How Psychological Biases Impact Your Decision Making Process
Simply put, when the markets have experienced a run-up on what is typically very good news, and price is at, or near, a quality supply zone, that is when we would be looking for low-risk shorting opportunities. Conversely, when the news is terrible and everyone is selling— provided we are near a quality demand zone—our focus should be to the buy-side.
I recently taught a futures class in Toronto, Canada the week the Federal Reserve had their latest meeting. Usually, those events add extra volatility to the market which translates into great opportunities. This day was no different. When asked by students what my directional bias was going into the meeting, I replied that based on the evidence my best guess was a substantial move lower would ensue. This was an assessment based on some of the odds enhancers that we had been talking about in class earlier in the week.
As the news hit the tape, the markets in their usual fashion began the wild gyrations. Some markets spiked into levels and bounced, while other supply zones began to form. One of those was in the Euro-Dollar futures. I instructed the students to short the Euro-Dollar in the zone shown in the chart below.
Recall that our odds enhancer had stacked the probabilities in favor of shorting, and as soon as quality level formed, setting up the trade was the only thing left to do. Still, there was a chance the trade could have stopped out as sometimes happens at what are seemingly quality levels. In this particular class just like in all others, we got stopped out plenty, but most important was the risk versus reward. In other words, the win-loss ratio is not as important as the average loss versus average profit.
The lesson here is that when the odds are most favorable to take a direction (strategic bias) then by all means, be aggressive. Measure your risk and reward, and if it fits the plan, execute.
Until next time, I hope everyone has a great week.