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The Trend is not Your Friend
So there is so much to talk about this week. I could talk about how the SNB nearly destroyed the FX retail business in a matter of 24 hours. I can talk about how much fun I had in VT trading chat room where we banked so many pips that I stopped counting by end of week. I can talk about how I went from sheer elation after being on the right side of the EURCHF trade to complete panic when FXCM announced that they were basically staring into the abyss of bankruptcy to absolute relief when they found a White Knight just before the close of business on Friday.
But the most interesting thing to cross my desk this week was actually a throw away article on Marketwatch that revealed something fascinating about how money is actually made in the capital markets. In a piece titled Easy way to get rich: Buy the most hated stocks Brett Arends basically lays out the case for contrarian trading. Arends looks at 10 worst ranked stocks in the S&P 500 as named by Wall Street analysts and discovers that 100,000 invested into 10 most hated ideas every year since 2008 would have turned the portfolio into 270,000 dollars. Just investing into the broad S&P 500 you would have made 170,000 dollars.
That is a massive difference and I think it says a lot about how alpha is really generated. Don’t get me wrong. I am not arguing that the way to riches is just to blindly bet against the trend. That in fact is the way to ruin. And if you are a long term investor who really doesn’t have the time or inclination to follow the markets them the old and boring dollar cost averaging strategy of buying a fixed amount of index funds every single month come rain or shine is the absolutely best way to make your money grow. In the long run the trend does win.
But if you are a trader, the profit does not lie in the trend. Of course the obvious can sometimes be incredibly lucrative. Shorting oil as it continued to fall or selling EUR/USD as it broke 1.2000 were both great trend trades that made gobs of money. But the problem with those examples is that they are very much like lottery tickets -- incredibly seductive but utterly disappointing for 99.9% of us who try them. Just as the lottery trots out the winners and lets us vicariously wallow in their good fortune while conveniently forgetting about the millions of wasted tickets, so does the trading industry love to pull out massive multi-year charts of trend moves with very conveniently tagged labels -- if you entered here and exited here you would have made ten trillion percent!
But in reality how many people can really catch a trend? How many successful trend traders do you know? How many successful trend trades have you ever had .. IN A ROW? Yes of course you will catch an occasional big one and then most likely will spend the rest of the year giving back your profits in a series of endless retraces.
The truth of the matter is that the more I trade, the more I realize that the profit is in being in the minority. This is by no means easy to do, and it certainly doesn’t mean fading every rally or buying every dip, but it does mean that to make money consistently you need to be on the opposite side of the price because it is only at those extremes that you have a better than 50/50 chance of being right.
The VT day trading system that we use in the chat room proved that in spades this week. In the midst of some of the most vicious volatility that we’ve had in years, the rookie traders in my room managed to not only survive but to thrive by doing what was uncomfortable but ultimately profitable and the experience just served to convince me once and for all that the trend is not your friend.