Last week I talked about a few changes I have observed in market players over the last 15 years. My theory is that we have gone through a process that has resulted in a market that is predominantly “trading” rather than “investing”, and that similarities have grown in the trading styles of the market participants. Institutions are investing increasingly in hedge funds to boost performance, and in doing so they are taking on more of the short-term style of the swing and day traders. At the same time, the remaining individual swingtraders and daytraders, who were largely responsible for the irrational exuberance of the late 90s, have wizened up, become more disciplined, and taken on more of the conservative characteristics of institutions. With market participants adopting similar styles, this would mean that much of the market is trading the same stocks, with a similar short-term approach.
What I want to know as a momentum trader is, what are the implications of this and how does it affect my trading?
In the past, momentum traders made their money by staying segregated from institutional activity. Blue chips were boring. Growth stocks were moving. So we bought Books A Million (BAMM:Nasdaq) at 4 and sold it at 45 two days later in 1998, while institutions were left whining about P/E ratios. We never let things like logic or fundamentals stop us from taking advantage of an absurd situation. We traded small stocks that had no institutional interest, and rode our own momentum.
Today, the game has changed for the momentum trader. The idiots are pretty much gone, so we aren’t seeing many stocks flying like BAMM anymore. Penny stocks are not moving much. The daytraders today are more conservative and methodical, so they are sticking with the larger more liquid stocks, keeping tight stops and taking reasonable profits. And institutions are now playing our game. So instead of making money by staying segregated, it has become indistinguishable whether we are riding institutional momentum, or our own. The game has become “When in Rome…”
If the market is indeed dominated by what in essence are really good, very disciplined, short-term traders, they will all behave very much the same way. They will all be setting reasonable targets and keeping tight stops. Not many will be catching falling knives. Not many will be chasing runners, creating euphoric illogical momentum. These are pros. The implication of this is that it could keep the market moving in narrower, choppy ranges. We would see less sustained momentum.
Another aspect of this, that I mentioned last week, is that I am seeing traders increasing the number of shares they play in order to extract equal profits from narrower markets. A friend of mine started trading a larger portfolio for a group of investors. He is trading a much larger number of shares now, than he previously was when he was just trading his own money, and its interesting to notice the changes in his trading as a result. He has become a lot more conservative, and is exiting trades a lot earlier. An increase in shares means an increase in risk. And for any good trader, that means an increase in cautious. But if the market is trading in narrower ranges, causing traders to increase shares and become more cautious, their caution contributes to the cycle of narrower ranges. He recently commented, “I am working twice as hard, for half as much”.
If the market is largely short-term oriented, trading rather than investing, we will also see much stronger and faster reactions to news that may affect the market. A great example of this was the day that Google Inc. (GOOG:Nasdaq) CFO George Reyes made a comment about advertising revenue slowing, and the entire Nasdaq took a dip. Another example was the recent FOMC meeting, when the market dropped dramatically after the announcement, then rebounded the very next day. Those were clear signs that a lot of the market is hypersensitive to any news that come down the pipe, reasonable or not. They are also very quick to pull the trigger, so you know they aren’t investing.
If the market is focused more on the short-term we will see stronger reactions to technical barriers. Investors research fundamentals, while traders rely more on technical analysis. I am one of those who believe that technical analysis often works as a self-fulfilling prophecy. Indicators like support and resistance, moving averages, and trendlines, are all predictive. So the more people who watch and respond to them, the more predictably we will see turns at those levels. So in a trading market, those technical barriers become more relevant.
How does all this change the way I approach my trading? When in Rome, do as the Romans do. As a momentum trader, I need to go wherever the predictable momentum is, and accept whatever the market is offering at the time. So first of all I need to track and find out where the action is. If the only action is in narrowly ranging, higher-priced stocks, then I need to play along and set my targets accordingly. It becomes very important for me then to track the average ranges of my stocks in play and make sure that my targets are reasonable. Any good traders knows, you make your money by being a little faster and a little more disciplined than the next guy.
Next, if the Romans are all using technical analysis, I better pay attention to those technical barriers too. I have always been primarily a tape-reader. When you are playing high-momentum news stocks, they will jump pretty far away from any trend lines. The news and large price jumps, puts them in a category all to themselves, and in those cases tape reading will be your best bet. In a market that is moving on technicals however, it becomes crucial to learn and adapt. So I have incorporated technical analysis into my longer-term, as well as short-term trading.
Never take your eye off the ball. News can hit at any time, and in a market that is short-term oriented and sensitive to news, you can’t afford to get caught not paying attention. Over the last two years I have found that I am following more obscure economic news than I ever have in the past. And it has become especially important to watch for economic reports that come out around 10am. If you are a beginner, I recommend exiting trades before news hits. It also helps to become familiar with the different economic reports and track which ones have been causing recent stirs in the market. Some get a jolt, and some get a yawn.
Finally, even if most of the predictable action is in the higher-priced stocks, I still want to keep an eye on the small stocks. Blue Dolphin Energy (BDCO:Nasdaq) was a good example this week. They are my gauge of how many amateurs are entering the market. If I start seeing increasing activity there, and predictable patterns developing with them, it often means the general market is heating up. And we all know enthusiasm can be contagious and profitable.