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The problem with reversals

One of the curious elements of human psychology is the tendency to fade moves or to try to pick turning points in trends. When I started trading, this was how I started out–looking for patterns that showed a trend was ending and trying to take a counter-trend position. Over the years, I’ve seen many traders focus on fading moves–a few do so successfully, but most struggle. Social media technical analysis seems to focus on people trying to call tops and bottoms, often pulling in tools like sentiment and ratio analysis to show why a market is primed for reversal. We must be aware of this bias, know that it colors our thinking, and work very hard to see market action with objectivity and clarity.

As I’ve written before, calling tops and bottoms is seductive. From a public relations standpoint, all you have to do is get it right once; it’s amazing to see people consistently calling for reversals, being wrong time after time, and yet to see other people still following that advice. One reason this works is that we look so smart and feel so right when we do call those tops and bottoms that it’s easy to forget the accumulated losses from the failed trades would be very large indeed.

distIt’s also difficult because this is a very inconsistent game. For instance, many stock traders at prop firms specialize in fading large moves. They will wait for a news item to hit and for a stock to make a huge move relative to its normal trading history. ((Think about a $50 stock that normally has an ATR of $1 making a $5 move in less than a minute. Those are the kinds of moves we are talking about.)) These traders will take a position against that move and are prepared to add to it if the stock keeps moving against them. Down, buy more. Down, buy more. Down more, keep buying. These traders will often have long strings of winning weeks (or even years), but then may give back years of profits in a single trade, and be taken out of the game completely. I’ve seen it happen more than once. (These traders have a risk profile like heavy premium sellers in options–they may make you money for years, but they’ll blow you up in the end.)

There are psychological reasons behind many traders’ focus on fading, but I think this is really driven by a deep, fundamental misunderstanding of how markets work. Ask yourself: when a market makes a large move, a very large move out of all proportion to its recent history, what is more likely to happen? Is that move more likely to lead to another move in the same direction, or is it more likely to reverse? Though our inclination is to think the market has gone “too far” (and, perhaps, to be sorry we missed the move so we look for a reversal), it’s far more likely for a market to make another large move in the same direction after it has made a large move. (Mandelbrot makes this point and explains why it is so very clearly.) If we do not understand that, then we are doomed to be forever biased to reversal.

Consider recent market action: the bull market in stocks; the selloff in soybeans, corn, and wheat; strength in the Dollar; strength in bond futures. Are you automatically inclined to look for reversals? Do you see these charts, and immediately try to find where you can jump on board against the move? If so, you have a bias. It may even be a bias that can be harnessed constructively. I am not advocating blind adherence to “trend following” as a methodology, and there are tools that can be used to find trend termination trades (and I’ve certainly used those to good effect over the years). My point is that we need to understand how we think, how we see, and work to manage our biases with ruthless efficiency. Fail to do so, and we will quite likely fail as traders.

AdamHGrimes

Adam Grimes has over two decades of experience in the industry as a trader, analyst and system developer. The author of a best-selling trading book, he has traded for his own account, for a top prop firm, and spent several years at the New York Mercantile Exchange. He focuses on the intersection of quantitative analysis and discretionary trading, and has a talent for teaching and helping traders find their own way in the market.
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