Lessons from the Pros


Thinking Differently to Gain an Edge in the Stock Market

Any trader that’s worth his salt will tell you that he thinks differently about the stock market than most. This is where he gets his edge against the competition. In other words, good traders tend to be contrarian thinkers. Although anyone can say they’re a contrarian, going against the prevailing consensus is not easy and, in fact, can be quite difficult. This can be directly attributable to the fact that human beings have an inherent herding mentality that is tough to overcome.

Examples of this behavior can be seen in the notion that nobody likes to be a party pooper,or rock the boat and cause waves. It’s easier to conform. In trading however, going with the plurality is not always the best course of action. In reality, I would say that if you do follow the herd your results in the long term will be poor.

Successful traders don't follow the herd.

Along with this independent thinking of successful traders comes true ownership of their decisions. They will always only rely on their own process and hold themselves accountable for their results, never blaming or deflecting poor decisions on external forces for their losses in the stock market.

This leads us to the stark reality that the vast majority of people who attempt trading fail. If this is indeed the case, wouldn’t it make sense that trading in the opposite direction of these traders would be profitable? Well, it’s not quite that simple. There are times when the herd actually does make money in the stock market. It’s when the majority becomes irrational that contrarians must be ready to take a different stand. In trading, understanding the difference is key to being profitable.

When I got my first job as a broker back in the summer of 1987, I was fortunate enough to be around a very talented trader who taught me a great deal about contrarian thinking. He would tell me things like, ‘The market’s main job is to inflict the most amount of pain on the most people.’ At first I thought, wow, this guy is really cynical, and frankly, I didn’t believe him.  Later though, as I gained more experience, I began to understand exactly what he meant. This became really evident as I witnessed first-hand when the market would go into states of panic selling. Since the vast majority of investors are long-only, these periods would be very painful for the masses, and as the stock market reached its capitulation (give up) phase only the strong were left standing since most had to sell just to extinguish their pain. A contrarian should be able to spot this on a price chart and buy from these fearful sellers.

Fast forward to the present, the stock market has been very strong as of late, and no one really knows how long this rally can last. Just last week the Nasdaq Composite index hit an all-time high, and the Russell 2000 is near its high. One would think that because the stock market is at elevated prices a contrarian would be looking to short the market. This is not necessarily accurate.

Free Trading WorkshopFrom a contrarian viewpoint, an interesting phenomenon has been occurring.  Every time the stock market has even the slightest pullback, everyone jumps on the big drop is coming bandwagon. I know this because I see it in the sentiment readings that I follow. These show that traders start loading up on put options and inverse funds at every instance when the markets show any sign of weakness.  What’s also noteworthy is the amount of skepticism about the durability and quality of the rally. This leads me to believe that there are many investors that are under-invested, and at some point will have to chase this market as they feel that they’re missing out. This scenario is at odds with a market that’s peaking.

In my experience, the stock market tops when the last holdouts begrudgingly join the party and finally buy which coincides with the shorts finally throwing in the towel. At the time of this writing, I’m not seeing this. If we stay patient however, and look at the market objectively, the market will show us when it has topped. It’s at this point that shorting may have better odds of succeeding. Incidentally, since futures trading is a zero-sum game, being on the winning side of a trade quite often means you’re trading against the short-term consensus.

Until next time, I hope everyone has a great trading week.


DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.