Monday, January 29, 2007

Contrarian Trading versus Momentum Trading

A commenter asked a question that merits an extended response.

Consider these two antipodal styles of trading:

1) Momentum
2) Contrarian

Momentum trading is buying strong securities and shorting weak ones. Contrarian trading is doing precisely the opposite.

If IBM drops today from $97 to say $70 for whatever reason, momentum traders will be playing the short side, looking to whack upticks (and downticks). Whereas contrarian traders would be looking to scoop shares of IBM at its bottom.

Of course nothing prevents a trader from playing both sides, long and short, many times over in the course of a day or any timeframe for that matter. But for purposes of simplification, set that thinking aside. Psychologically, it's very hard to be looking at IBM all day, thinking it's in big trouble and shorting it and then later turn around and play the long side. Security prices are volatile, head faking constantly, and generally very schizophrenic. False signals include wild upticks or downticks, breaking headlines, overall market movements, or even the guy next to you's asinine commentary. Most people would go crazy changing their minds 50 or 100 times in a day. I have seen guys try this style; predictably they go crazy, and quit not long into their career. Their workdays become filled with profanity, paranoia, and outright superstition. When day traders are called "idiots", this is whom they are talking about.

By nature I have always been a contrarian and thus a contrarian trader. I wish I could switch hit and learn how to buy high and sell low but that talent seems somewhat at odds with my brain. God knows that momentum devoured contrarian naysayers in the tech bubble of the late 1990s. Likewise the recent run in real estate had no pauses either. One guy I knew was trying to buy a house three years ago. Though frustrated with the rising prices he did eventually buy something. He now philosophizes that in order to make money in this world, you just have to break down and do what all of the Morons are doing. He is obviously broken and now firmly in the camp of momentum - or at least until he gets whipsawed.

Is today the age of momentum? Not witnessing other periods I am unqualified to answer. Though today's large markets run on the steroid of electronic trading and move with the grace of tidal waves, I submit there's still a niche for contrarians thinking outside the herd.

So how to make money this way?

First of all, a contrarian has to accurately assess his risk. If my short goes ten points against me what will I do? Double up? Cover it? Go on a bender and ride it out? He should know this beforehand and size the initial trade accordingly. One can't shoot spend their wad on the first trade. They may be dead right about the future direction of the stock but dead wrong on timing.

A contrarian's time horizon HAS TO BE LONGER. Momentum is definitely supreme on a short-term basis. In today's market you won't find many successful contrarian day traders. When stocks open down 10 points, day traders generally look to sell them. Only arrogant Morons like me think about getting long.

When I do try to bottom pick, I only buy a fraction of my desired position and I try to be as patient as possible. As a rookie contrarian, I used to buy or sell way too early. Now my entry points are much better. Better entry points mean less doubling up, less benders, more sanity, and more money. Of course being too patient entails missing some bounces and retraces - it's a delicate balance. I vowed to load up on Dell this summer under $20 but when the time came I wimped out - or was too patient. The stock was trading with a 17 handle at its low in July; it hit $27.88 in November. Oh well...

I have three trading accounts. One, solely for intraday stock trades (almost dormant these days); another for futures trading that I use the most (daytrading and position holding - due to its leverage); and my overall bank/brokerage account that holds my scant long term holdings like Google and trades that I want to hold for indefinite horizons. Just for kicks, here is a snapshot of my current long term holdings.

Long - GOOG, CDE, NEM, GSS, PAL, SWC, and I have a bunch of CDE LEAPS (calls).

Short - QQQQ, PCCC

So you just double down until you cover your losses during corrections?

Usually I do. Again, I always start small and leave myself this option. But I need to have a reason to double or triple up or at least have had nothing in my original analysis change. For instance, I shorted the 30-Year Treasury Bond after this year's election - I deemed more socialists in Congress as definitely bad for owners of American debt. Even though it went against me right away and violently, I confidently sold some more into this loss. After all, once December was over, all sorts of stupid, market-braking ideas would be swirling in the Legislature: minimum wage hike, illegal alien amnesty, shackles for Big Oil, etc. Now if I was short the bond before the election and the socialists were routed by newcomers hellbent on entitlement reform and tax cuts, then I probably wouldn't have doubled up on my bond short; I may have even covered it.

So though I do double up most of the time, I constantly monitor my original criteria and thinking. Much of it is dictated by feel and experience. Sometimes I let a Nasdaq short go 5 points against me, and sometimes I let it go thirty points before whacking it again. Of course once in a while I just cover it, take the loss, and move on. It would be very difficult and tedious to sit down and formally tabulate all of my rules for entering and exiting trades; though if endeavored it would probably add some clarity to my own thinking. I am saving this for the day when I hire some young strappers to trade for me.

Now, if the market moves big on say "smoke in NYC", "Bin Laden captured", or some other unconfirmed rumor, I'll swing the big aggressive bat right away and take a massive position. In these rare opportunities, he who hesitates is lost. All traders can count numerous once-in-a-lifetime trades that in the heat of a volatile moment, they were too scared to make or did too small in size. I am not talking about simpleton hindsight; I am talking about risk-free, edge-full trades that could if not enable retirement, could at least permit a year or two of vacation. Even many years later I can vividly remember my worst squandered opportunities.

Isn't this dangerous? The amazing thing to me is that you have not had a substantial loss trading against a strong market. How do you do it?

Doubling up on losers or "dollar cost averaging" is incredibly dangerous. One just never really knows how far a stock will move. Five and fifty dollar stocks alike go to zero - quite often actually. The same goes for shorting. I know guys who were short Dell, Amazon, and Iomega in size for hundreds of points during the late 90s. The markets will continually surprise even experienced traders, year in and year out - write that in stone and put it next your buy button. Inexperienced traders should really just start off with short term momentum trading because they don't as yet have the savvy to avoid major disasters.

My futures account has been very volatile these days. As I stated, I have been short the Nasdaq for much of this recent run. From November 6th through November 22nd, the Nasdaq was up 13 out of 14 trading days. Those were a painful two weeks. There were simply no dips to buy back any of my short. Ideally, I like to short things, have them come in, cover, and then reestablish them on big bounces. Most people have no clue how volatile the markets really are. They see a 10% return on their mutuals at the end of the year and are as happy as pigs in poop. Last year the Nasdaq 100 started the year by dropping 14% and then bounced 25% from its August low. And this is just the broader index, individual stocks and of course options had investment returns all over the map. The reality is, there is so much more money to be made from trading; as of now, only rich investors (hedge funds) are benefiting from it.

So answering Tax Shelter's question, I did get really hurt this fall in the Nasdaq, but was able to flip the futures enough times to offset what I lost on my stubborn position. Luckily, I have made all of that money back plus some dough on my End-of-the-World Trade. I was no doubt fortunate to escape unscathed, but believe me, I've been Lady Luck's b*tch aplenty.

What's inherently stupid about contrarian trading and doubling up is that a losing position is technically telling you "you're wrong". It's always foolish to argue with market forces but particularly so with the humbling financial markets. Think about it, what makes more sense, doubling up on your losing ideas or your winning ones?

Over the years I have gotten much better at understanding and occasionally utilizing momentum-based strategies. Though mentally a contrarian, my trading pedagogy also did its part to bias my skill set. Remember I started as a options trader, market-making on the floor of the Philadelphia Stock Exchange. I was originally schooled to buy options when they were cheap and sell them when they were expensive - all calculation based on the quantifiable metric of historical price volatility. My brain was programmed to see value in price and nothing in trend.

It took a couple of years, but once I started making money trading options in my pit, my ego decided to take on the larger market. I decided to parlay my winnings into foolish contrarian bets like shorting Coca-Cola, Home Depot, the Dow Jones Industrials, and IBM. Tragically for me, this was in the middle of the bull market. In that first foray, I committed a the cardinal sin of shorting stuff simply because it was "too high"; and I recklessly doubled up on all of them. In fact, I quadrupled up on IBM. The total damage wreaked by my contrarian ego that year -$220,000.

How's that for a one-year, educational tuition?

There are many traders that will absolutely never buy a stock unless it's in an uptrend. If I had a nickel for every time I heard a trader say "picking a bottom is like trying to catch a falling knife" I'd be retired on a Hawaiian beach by now. As for doubling up on losing positions, a veteran trader (himself Jewish) once told me that "dollar cost averaging has killed more Jews than Auschwitz".

Trading is in many ways analogous to the golf swing. There's no set right way to trade any more than there's one golf swing apt for everyone. Every style has its strengths and weaknesses and each participant is limited by their own inherent abilities and resources.

Consider this wire item last week from,

Google: Jefferies reiterates Buy ahead of Q4 earnings (499.07)

Jefferies reiterates their Buy rating and $520 target on GOOG ahead of what they believe should be stronger than consensus 4Q06 earnings, driven by both volume (incremental market share gains) and pricing (monetization improvements).

Do you spot the inanity? Google is currently $499.07 and Jeffries, a brokerage concern, is reiterating their recommendation to buy the stock EVEN THOUGH it's price target is a mere 4% higher (these are generally intermediate to long term investment ideas - not short term trading suggestions) . Who in their sane mind would buy a stock, race horse, or gas station with an advertised 4% return? That is what one gets in a money market these days. What unmitigated rubbish!

Again, for making real money, trading is where it's at.

Let's wrap it up.

One note about momentum trading. To be successful with this strategy, one has to sit there all day and stare at stocks (called "reading the tape") to get a feel for where they're headed. Remember I watch two small kids at home I can only trade part-time. Just too many diapers and bottles to study every tick of AAPL or BIDU. So my family priorities somewhat preclude me from really indulging in too much momentum trading. I could of course put my kids in daycare or hire a South American nanny - but I am not an a**hole like all of these other parents. If you don't want to see your kids grow up and instill your values in them, why procreate in the first place? Oops, sorry for that off-topic editorial.

Anyway it's just a whole lot easier to be a contrarian trader when part-timing it.

Summarizing, momentum traders work harder and earn more consistent money. While contrarians work less have bigger profit swings.

It's almost perfectly analogous to the contrast between the option buying and option selling strategies. Option buyers lose a small amount of money each day but connect on occasional home runs. Option sellers make small amounts of money each day (even on weekends) but give it back in big nasty chunks. What a great topic for my next trading post!

Interestingly enough, with options I have been evenly split between the buying and selling of premium - while most option traders I knew lean hard one way or the other.

Now if only I could add some more momentum trades to my current trading and balance out my contrary nature...


The Owner said...

This was a great post. There was a lot of good advice and basic acquired-expertise type knowledge in here, I'll probably come back and reread this again in a few days, and then in a few months after I have read some more investment literature. Suffice it to say, you've gotten me more interested in trading once again.

I know there are a lot of contrarian investors out there, but do you read anything by/have any respect for Mark Skousen?

Tax Shelter said...

When I do try to bottom pick, I only buy a fraction of my desired position and I try to be as patient as possible.

This probably is the reason that most traders are undercapitalized, i.e., if they follow proper trading techniques and control position size, they won't make enough money to make it worth awhile. One must have a lot of capital in order to make a living trading this way. Having access to the firm's capital is one of the edges that Wall Street traders have.

It would be very difficult and tedious to sit down and formally tabulate all of my rules for entering and exiting trades; though if endeavored it would probably add some clarity to my own thinking.

Just a wild guess: start small, double down or pyramid up, exit (hopefully with a profit) in a few days or weeks.

I am saving this for the day when I hire some young strappers to trade for me.

How do you keep them once they are trained and start to make real money?

I did get really hurt this fall in the Nasdaq, but was able to flip the futures enough times to offset what I lost on my stubborn position.

so the loss was due to bad psychology? Was there a predetermined point where you would cover if the market moved against you?

Ideally, I like to short things, have them come in, cover, and then reestablish them on big bounces.

How do you determine where or when to cover?

CaptiousNut said...

tax shelter,

Yes, Wall Street's access to OPM (other people's money) as well as firm capital allows them to trade in real size. But remember 1,000 square feet in Manhattan costs a million bucks. Also, their bonuses are discretionary.

There are guys that trade profitably and NEVER double up or pyramid in. My style is its own and there are untold more out there - definitely much better ones.

The only way to keep traders is with profit sharing or vesting some of their earnings over many years. If one trains people to be independent traders without any tethers, soon they will be totally independent traders.

Who knows what this particular Nasdaq loss was really due to? Bad luck? Obstinacy? Impatience? One will never really know for sure - so why torture the brain? Patterns of losses can better pinpoint flawed strategies. Remember the perfect trading strategy is a perpetually moving target. The market just evolves too fast. What is clear however, is that I should have been long instead of short!

I don't make a predetermined exit point - some guys do and swear by it. My exit points are still subject to my almighty discretion. I have tried using stop-loss orders and it only made my trading worse.

Your last question can't be answered well with generality. I'll have to find a clear example for you. But later on - you already got one entire blog post answer!!!

Mark said...

Re: "a veteran trader (himself Jewish) once told me that 'dollar cost averaging has killed more Jews than Auschwitz'."

Interestingly, back in the 90's, fund manager Dick Fine told my dad (and institutional broker at the time), that "Bottom-picking killed more Jews than Auschwitz".

It was actually implied that I was an anti-semite for sharing that.

CaptiousNut said...

Hi Mark,

Yeah someone accused me of *anti-semitism* for the same. I had thought it was in this post but it was probably in another post where I mentioned the expression.

On the trading floor we used to call our fellow Jewish traders *cheap* right to their faces. The Italians were call called *dagos* and *greaseballs*. Etc. No one cared; this is the real world as opposed to the faux realities of academia and Big Media.