Today is Part 6 of our 10-Part Series on Smarter Trading. The topic is “Sell Greed”.
The following is an excerpt from one of the chapters in Buy the Fear, Sell the Greed – 7 Behavioral Quant Strategies for Traders. The actual strategy it refers to at the beginning is called “CRASH”, a strategy that was created to identify extremely oversold stocks. Out of respect to the people who purchased the book, I can’t publish the strategy here. What you will get from today’s lesson is the importance of understanding that stocks and ETFs, at the correct time, can be successfully shorted, especially if risk is contained. What you’ll also read here is a story, as told by the great trading author Jack Schwager, of a very successful trader who has made much of his money from shorting stocks, even in the strongest bull markets. I hope you enjoy and learn from this lesson.
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This is a story about greed. It’s a story that gets played many days on Wall Street, especially in bull markets. It’s a story about making a lot of money and needing to make more. And it’s a story of people watching other people making a lot of money, and they panic because of the behavioral phenomenon known as FOMO: the Fear of Missing Out.
Greed at extremes often creates absurd prices for securities, especially when it’s short-term greed when rational people lose their senses and mindlessly buy. As all of market history has shown, though, what goes up must come down. And a lot of money has been made from smart money taking the other side of greed. CRASH is our strategy to (legally) take money from greedy people.
CRASH is a strategy that “sells the greed.” It’s a short-selling strategy that in spite of a raging bull market over the past nine years, has consistently identified and pinpointed when greed has been extreme in individual stocks and in the majority of cases prices have reversed lower almost immediately.
The strategy is simple, elegant, and robust. It’s also psychologically likely going to be the hardest strategy for you to trade.
Taking a CRASH trade is going to be very difficult for most traders because the stocks it shorts are usually moving parabolically. And many of these are being driven higher by speculators, the news media, social media, and massive short-covering. These stocks are very often “story stocks on steroids.” And story stocks on steroids brings out the greediest worst in investors, traders, and speculators. All rationality gets thrown out the door. Sometimes these buyers are right and the stocks continue to go even higher. But more often they’re wrong — incredibly, over 70% of the time they’re wrong when they’re buying these stocks after they have run so far up.
Who wins when these irrational buyers are buying for no other reason than greed? The traders smart enough to know that the greed is extreme, and they’ll gladly sell into these short-term, greed-induced bubbles.
In his book Hedge Fund Market Wizards, legendary author Jack Schwager interviewed a professional trader by the name of Jimmy Balodimas. Most of the traders Jack interviewed over the years for his books had compelling stories. Jimmy Balodimas’ story, though, was one of the most compelling because he was the only trader who up to that point had made most of his money “exploiting traders’ greed.” No matter how strong a bull market was, Balodimas was consistently able to step in at the right times and sell into the greed. Bull markets steamroll most short sellers, but at the time of the interview, Balodimas had reportedly made many millions over the years selling to greedy irrational buyers at the right time. As Jack inferred, most professionals would be skeptical that someone could consistently do that. Not only did Balodimas do it, Schwager’s son had witnessed it for years while working directly for Balodimas.
If you read the interview one thing stands out. Balodimas thrived in overbought, greed-induced situations. And he wasn’t afraid of becoming even more aggressive even when prices moved against him and the greed became even greater. Selling greed was how Jimmy Balodimas made his living.
Most of us don’t have the innate skill that he has and have the same conviction to sell short at extremes. We’re going to need to go further and apply strict disciplined quantified rules that identify these times.
This book is a combination of behavioral finance being measured through quantitative test results and that’s exactly what we’re doing here with CRASH. The behavioral aspect is very important because it creates the edge. There’s a “mob mentality” associated with most CRASH setups. This mob mentality creates the extreme overbought conditions. From there disciplined rules go into place combining behavioral finance with quantitative evidence.
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Selling greed is a real phenomena and as you read above for some traders its been a lucrative business. If the market is turning now and beginning to move into a bear market, having the knowledge of when and how to short stocks and ETFs at the right time has the potential to make you a far more profitable trader.
In the next issue of the Connors Research Traders Journal we’ll look at the importance of trading systematic quantified strategies.
Enjoy your trading!
Larry Connors
Connors Research LLC