Don’t jump in front of a moving train!
This week’s article is meant to address an issue I have recently realised is more prevalent among retail FX traders than I initially thought. The issue of ‘jumping in front of a moving train’, as I prefer to call it! Its inverse being ‘catching a falling knife’.
‘Catching a falling knife’ is a phase generally used in trading describing the action of traders as they try to buy a falling market; whereas is ‘jumping in front of a moving train’ will be traders trying to short a rising market. (My analysis in this article is more biased on the later, that is, jumping in front of a moving train).
Watching the recent rally in markets like the EURUSD, Gold and Silver, I couldn’t help but notice how some of our traders were shorting these strong uptrending markets hoping to profit from potential trend reversals.
What was even more sad to watch though, is how some were ‘crushed’ by these markets as they refused to be wrong, and kept their shorts, as they were convinced the rallies were not sustainable and a reversal was imminent.
This brings me to my first point; markets can actually stay in unsustainable uptrends for longer than anticipated; or put differently, markets can stay irrational for longer than anticipated.
#1. Markets can stay irrational for longer than anticipated
One of the biggest assumptions underlying any attempt to short new highs, is the belief that the market has risen too far, too fast, and that it is due for a pull back. This is of course a recipe for disaster as some uptrends tend to persist for much longer than predicted/forecasted by technical or fundamental analysis.
Traders often employ the use of technical indicators such as relative strength index (RSI) to classify a market as overbought, thereby justifying the belief that the market has risen too far too fast and hence due for a pull back. And indeed, under certain conditions, an overbought market tend to reverse (or correct). But sometimes the market doesn’t ‘correct’ as anticipated and can thus stay ‘irrational for much longer than expected’.
I refer you to a recent daily chart of the EURUSD, for context:
As can be seen on the chart, the market started hitting overbought territory at prices around 1.1400; but the market rallied more than 300 pips since then; of course, to the detriment of traders who had shorted the market in anticipation of a ‘correction’.
Gold is another example. Look at the chart below where the precious mental started trading in overbought territory around $1800, but the market would rally more than $100 in the next few trading sessions to hit record highs. And the RSI now has a reading above 80 (indicating way overbought conditions), but the precious metal is still ticking higher!
#2: Short covering
Another factor that makes it dangerous to short strong uptrends is the effect of short covering. In layman’s terms, short covering is the buying effect of short sellers as they cover/close their short positions; or as their stop losses gets triggered. Now, because the majority of traders see new highs or strong uptrends, as shorting opportunities, that usually provides the market with enough rocket fuel for even higher prices. All it takes is a few upticks and these traders start to cover, triggering a cascade effect that can add a lot of points in a short time frame.
As a rule of thumb: always avoid trading with the crowd; rather be a buyer when the crowd is selling and sell when the crowd is buying; that way, short covering may actually work in your favour.
#3: Big market players may not care much about technicals
Besides short covering, another reason why some uptrends may persist for longer than technically anticipated is simply because big market players may not be looking at the same charts that most retail traders will be looking at. Big market players, such as Institutions, whose buying or selling actions usually moves markets (as they buy/sell in huge volumes), sometimes may not be looking at the same chart that most retail traders look at. So when all indicators are showing overbought conditions on the daily chart for example; the big market players may be buying to hold for the next 10-20 years; so overbought conditions means very little to such institutional buyers, and they just keep on buying; and just like a high speed train, they crush the multitude of short sellers in their way.
The best way to trade strong uptrends
The best way of trading uptrends is by simply riding the trend. That way, you are trending in the way of least resistance. But I will admit, sometimes you miss these trends and by the time you want to jump in, it may seem too late. When you miss a trend, I always advocate for not chasing. That is the current case with markets like Gold, Silver and EURUSD at the moment. Inasmuch as they look good to rally further, it may be too late to take new ‘Longs’.
So, what do you do in such a situation? You simply wait!
The one good thing about markets, when analysed using technical analysis, is they will always give a signal or confirmation to either buy or sell. So before jumping to short, or chasing a market, always wait for confirmation that buyers are still in charge, or that sellers are stepping in.
Such confirmations mostly come in the form of such technical chart formations as bull flags, bullish consolidations, falling wedges, pennants; just to mention a few.
The same applies when sellers are stepping in, the market always confirms it buy way of technical formations and candlestick formations. This is where candlestick formations such as bearish engulfing candle, shooting stars, etc come in handy.
In terms of technical chart patterns; bear flags, pennants, descending triangles, etc; are useful in determining if sellers have enough charge to reverse the market.
The biggest take away here is: before shorting an uptrend, always wait for confirmation that sellers are stepping in.
A quotable quote in conclusion
“The danger of shorting a strong uptrend hoping for a reversal is not that it won’t reverse, but that it will actually reverse. That will be the beginning of a dangerous habit of fighting trends under the mistaken assumption that they ‘always reverse’; until that one trend that just won’t reverse.”
Until next time, let’s keep it profitable!
Head: Unum Capital’s GetSelected Division