Today, I want to follow up on last week’s article on trading.
I am fascinated by the fact that so many people fall for the same sales pitches about trading systems that promise to make you millions of dollars with minimal effort and hardly any risk at all.
The statistics on retail trading are readily available, and the evidence shows that over 90% of individual traders will fail to make money over time.
Add directional options trading into the equation, and the numbers get worse.
There is a time and a place for options, and we can talk about that later this week, but trading stock options because you think a stock will go up or down based on a chart pattern or set of rules is a losing game.
The reason why is simple – and the (profitable) alternative is right here…
When you trade an option, you are betting against enormous brain power backed by more computing powers that NASA uses to send men into space.
They are pricing that option to make it statistically unlikely for you to make money.
A new paper from finance professors at MIT verifies that retail traders have a negative expectation every time they enter an options trade.
As I said, we will explore options some more and talk about how you can make money with them later in the week, but for now, do not just take my word for it.
There is overwhelming evidence to verify that you are highly unlikely to make life-changing profits from options trading.
If you want to trade, and it seems damn near everybody does, there are two approaches that traders have consistently used to make a lot of money.
Both have pluses and minuses, and which you choose can be a matter of temperament, available time, and stomach for volatility.
Both will work if you heed last week’s advice and become very good at taking small losses.
The most likely trading methodology to make you an enormous amount of money is trend following.
The trend following is the value investing of trading.
Everyone has heard of it; everyone knows it has made many people rich, yet almost nobody does it.
Everyone knows that Warren Buffett, Seth Klarman, Carl Icahn, David Einhorn, and Joel Greenblatt got filthy rich buying businesses for less than they are worth.
Despite all the evidence, everyone is constantly looking for the next big thing. Most of the time, the big thing is the size of the losses they experience.
There is an equally overwhelming amount of evidence that trend following can make you enormous money if you stick to the rule and control risk.
You may not have heard of William Echardt, William Dunn, Jerry Parker, Ed Sekoyta, or John Henry, but rigid adherence to trend-following principles has made them ridiculously rich.
Most people are interested until they discover that the win rate for successful trend followers is around 40%.
You may get stopped out of a trade several times before the trade goes your way.
Your biggest winners will go against every headline and expert on the planet, and it will be lonely.
Your biggest winners will usually take months to play out.
The mindset that makes you a successful investor will work against you as a trend following traders.
Trend Followers never average down.
You will be buying market highs, not market lows.
You must use stops. Tight stops.
Fundamentals do not matter.
When markets are not trending (which is most of the time), You will have few positions, and those you do have will be taking a lot of small losses.
The upside here is that when markets do trend, you will make huge gains that more than offset your small losses.
One of the beautiful things about trend following is that you can trade markets like crude oil, currencies, and fixed income without knowing much about them.
All that matters is the price.
All the fundamental facts and figures will ultimately show up in the price. The fundamental truths often appear in price long before the so-called experts notice.
Because you have a lot of small losses and a handful of massive winners, every trade you enter has a large positive expectation.
That can be hard to remember after our fourth small loss in a row but remember that this is the key to making trend-following work.
Using trend following, you will never miss a significant market move.
Because of the tight risk control that is part of the strategy, you should never get caught up in massive moves against you.
Using a simple 200-day moving average rule, trend followers would have gone short stocks in mid-March of 2020.
You would have shorted stocks in January of 2008 and gotten back in during June of 2009.
Today, you would be long stocks, short bonds, and the dollar.
You would have bought into the NASDAQ 100 in January of this year and be sitting on massive gains.
You would also be long crude oil with small gains.
After a few small losses, you would have booked back-to-back losses late last year and early this shorting oil.
You would be sitting on huge gains in a short natural gas position.
You would have several small losses before the big moves, but you would be sitting on huge gains.
That is up to you.
You can determine your risk and ultimate rewards by varying the amount of leverage you use.
Today, you can use exchange-traded funds to go long and short and add or subtract leverage.
You can get up to 3x leverage on various markets and asset classes.
You can use futures if you really want to put the pedal to the metal.
There are mini-futures available on a wide range of contracts today.
So we can use options, right?
Although there are options traded on these products, keep in mind that the big brains and supercomputers are pricing the contracts to make it as difficult as possible for you to make money.
They will win most of the time
If you want to trade, trend following gives the best odds of success.
The best hyper-aggressive path to building wealth rapidly is using trend trading to pile up cash and then invest that cash in deeply undervalued stocks, especially banks and REITS (for my favorite way of doing this, see below).
Trend Trading and value investing work.
They are not sexy. They do not work overnight.
But they work exceptionally well.
The lists of successful investors and traders are comprised almost entirely of value-oriented and macro trend traders.
Directional options traders are nowhere to be found.