Let’s face it. By now, most traders have learned (often the hard way) that the best way to make money in the market is to do the opposite of what you want to do. Unfortunately it is human nature to want to follow and trade in the same direction as the market is moving. For example, we’ve all seen a big up day in the market where we got excited and went on a buying spree, only to see the market reverse the next day and put our positions in the red. Similarly, we’ve all seen a big up day in the market where we were not excited and did not buy anything, only to see the market continue moving to the upside over the next several days.
No doubt, many traders have been burned too often by following the market and subsequently give up. The market can truly seem to be out to get you sometimes.
For short-term swing traders, knowing when to buy strength and when to sell it will determine whether they succeed or fail. Sure, good position-sizing may mean they don’t lose all their capital, but unless these traders figure out how the market really works, they will eventually give up.
I’m here to give you the secret ingredient to the market recipe–the one that will help you know whether you should be trusting or fading a market move. This secret ingredient will help you know when to buy strength, and when to sell it. In short, this ingredient should be as important as your best indicator, your favorite technical pattern, or your favorite strategy. In essence, this ingredient will tell you when to do the opposite of what you really want to do.
Before I give away the secret, as with any ingredient, in order to use it wisely, you need to understand how it works and when to use it.
A Short Primer- Daily Follow Through and Mean Reversion
I’m highlighting Daily Follow Through (DFT) because it is a very basic yet robust method of figuring out whether a market is following-through or mean-reverting. While there are indicators which can describe/measure follow-through and mean-reversion, I believe this is the simplest method and therefore the easiest to understand and reproduce.
DFT describes the ability of the market to follow-through on a move (some may call it “trending”). If the market closes higher on Monday and then again closes higher on Tuesday, it has followed-through on Monday’s move. This is the opposite of Mean-Reversion (MR) which occurs when the market revisits prior price levels before moving again with the primary trend (This is admittedly an over-simplified definition of MR). A mean-reverting market will have the tendency to close lower on Tuesday after a higher close on Monday.
Over the past 15 years or so, any trader relying solely on DFT as a strategy has lost all of his capital. Since the mid 1990s, MR has been the driving force behind the U.S. markets. However, there are times when MR doesn’t work very well, and traders will need to adapt to a market environment which is based on DFT.
Part Two- Looking at the Results of a Simple DFT and MR Strategy
In part two, I’ll provide some statistics as well as chart porn for a simple DFT and MR strategy. We have to first examine when each worked and then compare the results to the broader market environment. Once that is complete, we’ll be very close to understanding the secret ingredient.
Comments »
