Although, having an edge will make you money in any business or market, I will explain how you can make money in the stock market by gaining an edge. Gaining an edge in the stock market does not come from being privy to some stock news before anybody else knows it, or even jumping into a stock seconds after a piece of news hits the wires. If you ever picked up a book on Dow Theory, one of the tenets of the theory is as follows: “The Dow theory operates on the efficient markets hypothesis (EMH), which states that asset prices incorporate all available information.”This pretty much means that you cannot trade news. This is especially true today with the internet where news travels at the speed of light, and algos can trade it way before you even have an inkling of what happened. Have you ever felt that the moment you bought a stock in an uptrend, it started falling or whenever you shorted a stock which was in a downtrend, it suddenly started going back up. That is how most traders lose their money. I call it the “Johnny come lately” syndrome. Never chase a stock on news. It is a battle you will never win!Now that we have that out of the way, is there another way of gaining an edge? And the answer is a resounding YES! The way you gain an edge in the stock market is by trading extremes. Stocks have a tendency of mean reversion. Whether it is an uptrend or downtrend, you can find a mean of the current trend. Whenever the price moves above our below that mean, 95% of the time it tends to revert back to the mean. What are these extremes that we can trade?
- Price Extremes – Whether it is an uptrend or downtrend, if the price movement extends way beyond the mean, most of the time it reverts to the mean. There are exceptions to it like Earnings, Mergers/Bankruptcy events etc. These events are called “binary events”. And one of the principles I have developed over the years is that I stay away from these events. There is no predictability of these events and it is better to stay away from them. I would rather go to Las Vegas and gamble, Yeah, I will come back losing my money but at least I can claim that I came back from a vacation 🙂
- Volatility Extremes- What is volatility? If a stock doesn’t move a lot and is mostly range bound, it is a non-volatile stock. I remember MSFT stock was stuck in a range for 10 years (I think they call it the lost decade). On the other hand, a stock like Priceline (BKNG) is extremely volatile. We are talking price movements that can be $100 – $150 in a day sometimes. When I publish my list of stocks I trade, you will notice that I like to trade these “high beta” stocks a lot. The more volatile they are, the more they tend to move away from their mean, which gives us trading opportunities. Especially when you are trading options, volatility gives you a ton of trading opportunities.
So, there you have it. To gain an edge, we spot market extremes and do a mean reversion trade, also called a contrarian trade. This also means you will never have FOMO and will never feel left behind when a stock takes off on a piece of news. Because you will have no interest in chasing a stock. All you will want to do is patiently wait for the extreme short term trend to exhaust so that you can take your mean reversion trade. In future posts, I will explain methods on how to spot these trend exhaustions and market extremes