Connors Research Traders Journal (Volume 15): 10 Smart Ways To Improve Your Trading; Part 5 Buy Fear
Many traders, especially traders who spend their majority of time reading charts and relying on indicators and oscillators, tend to forget that stock and equity prices are not only driven by supply and demand. They are driven by fear and greed.
It’s easy to say that a stock is making a double top, or is touching a trend-line, or its MACD reading is signaling an overbought or oversold reading.
25 years ago this type of trading was barely taught beyond the then-very small, small world of technical analysis. Today, it’s widespread mostly because charting has become a major part of every trading platform and few, if any, traders, outside of the quants, do any trading without some sort of reliance on charts.
The main problem with chart reading is even with it’s broad mainstream use, there is very little and, actually, next to no quantitative evidence it works. Yes, some traders do have better abilities than others to read charts and I’ve seen their success. But they’re the exception – not the rule. Chart reading is subjective and there are few rule-based strategies that rely only on chart reading that have shown long-term consistent test results.
This is not an article to diminish chart reading – if it works for you, keep it going. What the goal of this issue of the Connors Research Traders Journal is to quantify one place where quantified trading edges exist and have existed for decades – it’s in buying fear, especially in longer-term uptrending markets.
There are a number of ways to measure fear. They range from the subjective method of putting on CNBC and seeing how much fear is in place from their guests, especially after the market has sold off multiple days, or if a large event is looming. Going further, this subjective practice has been enhanced and supposedly automated by funds. There are quant funds who supposedly have the computational ability to measure this fear on television and they’ve even taken this to other areas including into the conference calls held with quarterly earnings.
This type of systematic reading of fear is beyond the scope of most of us but it does show that on this level, they believe they can systematically trade the emotions of others.
On a more practical basis for the rest of us, price movement and an indicator can do the same and I’ll show you how.
In my book Buy The Fear, Sell The Greed, I show a number of quantified, systematic strategies that have proven that fear, especially extreme fear, leads to quantified, repeatable edges for traders. These edges have existed for decades and even though markets have changed, emotions, especially fear, have not and in my opinion never will.
Stock prices and equity index prices when driven by fear provide you with opportunities. Fear leads to selling and at the same time fear also leads to a lack of buying. Why buy today when you can wait until an event has passed?
This lack of buying creates liquidity holes – this means buyers step aside and prices naturally move lower, oftentimes to levels where large historical edges exist. Then once the fear or event has passed, the money managers step back in again (it’s safer) and they usually buy at higher prices.
In their minds it’s safer for their investors (and their careers) to wait until the coast in clear. Oftentimes though when the coast is clear prices are already higher and the profits go to the traders who took advantage of the lower prices and then turn around and sell their stock to the money managers who are now buying it at higher prices.
This is a repeatable pattern played out year after year, especially in bull markets. In Buy The Fear, Sell the Greed you see this repeatable pattern quantified, systematized, and continuously occurring from last century up through the very present.
A simple formula to remember is this:
1. The stock or equity ETF is in a long-term uptrend. For example, it’s above the 200-day moving average. The 200-day simple moving average is hedge fund legend Paul Tudor Jones’ favorite indicator so you have good company.
2. A measurable pullback occurs.
3. Ideally, a further pullback occurs intra-day (turning fear into a short-term market panic during market hours).
4. Sell into strength defined by the price crossing above a short-term moving average or an overbought reading on a short-term indicator.
This formula can be applied by everyone. It’s not perfect, especially as a market transitions from bull to bear, but overall it has led to systematic strategy signals being correct anywhere from over 75% of the time to in some cases over 90% of the time since 1993 (this strategy is covered in Chapter 2 of Buy the Fear, Sell the Greed).
Fear creates edges. The greater the fear, the greater the edges. Buying fear is one of the few built-in edges that traders can systematically rely upon that is supported by decades of historical data.
In the our next lesson of our Series “10 Smart Ways To Improve Your Trading” we’ll cover “Sell Greed”.
Enjoy your trading!
Larry Connors
Connors Research LLC