5 Trading Myths That Should Be Busted
By: Steve Smith
Clichés and sayings become such because they usually contain a kernel of truth, and they typically come packaged in a short and pithy easy-to-remember statement.
The world of trading and investing is littered with such utterances.
It often contains some sort of rhyme such as “Sell in May and go away” which rests on the belief that the summer is a seasonally soft period where stocks underperform relative to other months. Indeed, there’s some data to back this up. However, the difference between the historically worst month of August and November/December, which are the strongest, is below an average of 1% over the past 50 years.
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Looking back over the past 3 years, the gains between May and August have actually been 5.6% higher than November and December. This August, the major indices such as “SPDR S&P 500 (SPY)” and “Nasdaq Power Shares (QQQ)” are up a whopping 5.3% and 6.5% respectively — in the first two weeks alone!
Here are five other ‘bon mots” regarding trading and investing which have gained more credence beyond their actual kernel (as a general truism).
1. The trend is your friend
This is certainly true to an extent, especially over the last decade as algorithmic trading has become an increasing force in hedge funds or actively managed accounts. These funds are basically set up to trigger buys (or sales) as stocks gain (or lose) momentum mainly as new highs (or lows) are made.
There’s also been a decided shift of even longer-term funds favoring growth (i.e. technology) overvalue (cyclical sectors such as energy) which can become a self-fulfilling process.
That is until another saying comes into play: “trend is your friend until the bend in end.” Meaning, when the momentum stops, the declines can be fast and furious.
And there’s yet another saying, “stocks take the escalator up but the elevator down.”
It has taken me years to take a “go-with-the-trend” approach and be willing to get long or take bullish positions in stocks that have already run up or are hitting new highs.
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However, I’m still cautious— particularly when it comes to the nature of options. I make sure to apply an options strategy with a well-defined risk/reward profile.
2.Hold onto winners and cut the losers
I always take my solid wins when they’re in the money. Let’s face it: I’m not training racehorses, I’m managing money.
And again, the nature of options is that they come with an expiration date. Occasionally, I might roll a position to gain more time. But, for the most part, I set up each trade with well-defined parameters for entry and exit targets. Once they’ve achieved, the position is closed.
3. Don’t add to a losing trade
Given that most of my trades are relatively short-term, I rarely go out to expirations beyond 3 months, and as mentioned above, if a set plays out in two days or two weeks, I’m gone like the wind and close the position.
So, while I usually don’t ‘average down,’ every now and then I take a position where I have a broader opinion beyond the near-term technical or option-related setup, and I’ll initiate the trade with a “half size” in anticipation as price moves against me, or as I put it, presents an even more attractive price.
For example, I and the Options360 service initiated a bearish position in “Moderna (MRNA)” two months ago using a put spread with an October expiration — when the stock hit $80 and then added additional contracts two weeks later, when it spiked to $96. Shares are now below $70 and the position is showing a nice profit. My target to exit is $60 per share, which would deliver a 450% profit.
To be fair, this approach proved disastrous in “Tesla (TSLA)” when in 2016, I started a bearish position with a six-month horizon when shares were just under $200. I added a month later when it hit $230. I threw in the white flag with a substantial loss when it crossed above $250. I’ve not traded TSLA since.
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4. Always be contrarian
This also comes with corollary sayings such as “don’t try to catch a falling knife,” or more appropriate to the current environment, “don’t stand in front of a charging bull.”
My nature is to buy dips and sell rips. However, unless there is discernible support or resistance, I steer clear trying to pick tops or bottoms. In sports, this is sometimes referred to as ‘hero ball,’ as it’s wonderful when you nail it, but the probabilities won’t be in your favor.
Likewise, data shows hopping on winning trades, or once the aforementioned “trend” is established, superior and more consistent returns are delivered over time.
5.”Be impartial, don’t let your feelings/psychology affect your trading.”
As someone that uses technical analysis and applies the math-based probabilities in options strategies, I mostly adhere to the notion that emotions shouldn’t come into play in your decision-making process.
But, we’re all human and sometimes a trade doesn’t feel right even if none of your parameters have been violated.
In this case, it might pay to listen to your gut, because it might mean the trade or strategy type just isn’t right for your style.
I strongly suggest that you don’t fight your instinct or comfort level — if you’re constantly checking a position minute-to-minute, or losing sleep.
This brings us to my most important point: People that might be good traders, listen to others making rules and often quit. Find your trading personality. It could be five minutes, long gamma, or something else.
In establishing each individual trade I always use the options strategy that best aligns with your thesis.
In a broader sense find the style, whether it be steady income credit spreads or leveraged volatility trades that best suits your personality.
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