Friday, July 15, 2016

Mind the Gap ... up or down - Fade the extremes if you know what is an extreme

It was Jim Rogers (co-founder with George Soros of the Quantum Fund) who when asked how he makes money replied, “I buy fear and sell greed.” Then he was queried, “How do you determine when there is fear or greed?” He responded, “I wait until prices start gapping in the charts!”

Jim Rogers is talking about counter-trend trading the market extremes. Buy when markets gap down on fear and sell when markets gap up. Look for excessive trends and then fade.

According to the economist Herbert Stein, "Something that cannot go on forever will stop". I can add the corollary, "Anything that goes up much faster than normal, is likely to reverse with similar speed". Strong momentum makes traders complacent and lead to speculative excess as more investors try to get on the bandwagon and not be left behind for what seems like a good idea. Strong momentum is all the more suspect when the overall environment is inconsistent with the price action. You cannot have sustained rising price increases in a low growth economic environment. 

With 24-hour markets and global trading, market gaps are somewhat harder to measure or find, but the thought concerning market gaps still makes sense. Trend-followers generally will always stay in trends, so trend-followers will be able to exploit the build-up of greed and fear. There is no reason to cover long or short positions that are above or below trend lines, yet there are defined measures of overbought and oversold. Too much of a good trend will sow the seeds for speculative excess and a reversal. This is the crash risk often discussed with momentum and trend strategies. 

The real difficulty for buying fear and selling greed is knowing the extremes. This is not as easy as most think. Overbought and oversold measures have spotty history. Additionally, an investor has to offset natural tendencies to avoid fear or risk and seek easy money with greed. Relative strength of momentum and tail risk measures are good starting points but the distribution of prices are all the more difficult to measure when there is a change in equilibrium prices. This is why most investors prefer trends and also why once the price reversal occurs there is financial carnage. 

So a simple rule is a good start for any action on exploiting extremes. Price gaps are warning signs that require profit-taking as a minimum action. Risk is reduced with an opportunity cost of being early, but the cost of crash risk is minimized.

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