Monday, March 22, 2010

PICKING A TOP

I often see traders trying to pick a top. It seems to be their favorite pastime.

But I have to pose this question. Is it really worth the trouble?

I think when I'm finished you will see that it not only isn't worth the effort but is actually one of the single worst strategies anyone can choose.
 Picking tops is the bread and butter trade of Moe Ronn (our fictional character representing the average impatient trader).

Let's say Moe thinks the market is due to top out and roll over into a bear market based on his interpretation of the fundamentals (either real or imaginary, it doesn't matter).

So Moe decides he's done with the long side of the market and he begins shorting in an attempt to spot the top. He makes repeated attempts to short, taking multiple small losses while he waits for the expected turn.

 Now let's say Moe finally gets lucky and shorts XYZ stock at the exact top of $100. Let's also assume that Moe manages to hold on through the extremely violent whipsaws that almost always occur as a bull market slowly rolls over. This is a huge assumption, but just for the sake of argument we're going to give this one to Moe.
 Let's also assume that Moe manages to exit his short at the very bottom with XYZ trading at $20. Moe just earned himself a very nice 80% return minus however much he lost trying to pick the top.
 Now let's see how John I. Que goes about trading a bear market.

Let's say John also thinks the market is due to roll over into a bear phase and he too wants to short XYZ. First off, John doesn't attempt to try and spot the top. He knows that is a fool’s game. John just goes to cash and waits patiently for a sign that the bear has truly returned.


Eventually XYZ rolls over and sinks below the 200 DMA. By this time XYZ has lost $20 already. At this point John is confident we have now entered a bear market and he sells short XYZ. John also manages to exit his short close to the bottom at $20. John just lost one heck of an opportunity because he was late to the party, right?
 Not quite. In fact, just the opposite.

Consider that the drop from $100 to $20 was an 80% gain for Moe's short. Not bad, not bad at all. But the move from $80 to $20 was a 75% gain for John's short. John only gave up 5% by waiting until the bear clearly declared itself and in the process avoided the many false starts that Moe had to suffer through in trying to pick the top.
 In reality John most likely made more money by missing the top by $20 than Moe did by eventually timing it perfectly.



As I mentioned last week’s article 1-2-3 reversal, the market is due for a move down into a daily cycle low any time now. So the thing to do is sell short, right? What are you crazy?

This is a cyclical bull market and one of the most powerful bulls in history. You have to be crazy to sell short into something like that. Let’s face it, in a bull market the surprises come on the upside. The correct course of action (assuming one doesn’t just plan on riding out any corrections) is to go to cash, wait for the pullback to occur and then buy into the dip.
 If we were in a bear market the opposite would be true.
 Counter trend trading is probably the single biggest mistake that the average retail and professional trader make and it stems mostly from impatience and the inability to just sit in cash.


As long as one trades with the cyclical trend any timing mistakes will eventually be corrected. A timing mistake against the trend will be amplified.


It’s such a simple strategy and if followed religiously, it is a strategy that would improve trading results by probably 10-20% over an entire career.
 Even the best traders are doing good if they can win 60% of the time. Can you imagine what the difference over a lifetime of trading another 10-20% would be? I dare say it would be large enough for Moe Ronn to change his name to Moe Money!

2 comments:

  1. thanks for your insights, picking a top peice is spot on

    i've been considering your run away move up thesis and the move out of the mid-70's lows comes to mind

    time will tell

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  2. I am actually refering to the stock market being due for a brief move down into a daily cycle low before moving higher.

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