The love/hate relationship all traders need to prosper
Do you remember September 2007? The DOW Industrials stood at $14,198.10. You could buy a house under construction and sell it for a 25% profit before it was even finished! Traders’ greed drove the valuations through the roof!
Everyone knew that housing prices only went up and everyone had to own the most expensive home they could afford. The only reason not to get rich flipping houses and stocks was that you just didn’t know a sure thing when you saw one.
By February 2009, the DOW was down 50% in 18 months. Housing prices had fallen even more in many areas.
Prices had soared to ridiculous heights by 2007. Then they fell even more quickly to outrageous lows.
So what drives these extreme valuations in markets?
In 2006 unbridled greed drove people to convince themselves someone else would always pay more for their homes or stocks. Just like a Ponzi scheme, eventually the market runs out of new buyers.
Eighteen months later, it was a completely different matter. Fear was everywhere and the bottom was nowhere in sight. The market was filled with millions of desperate sellers but not many buyers. Do you remember the gut-wrenching turmoil you felt at the bottom of the market in early 2009?
Who wouldn’t have been scared and depressed? The world as we knew it seemed to be ending. Life would never be the same again. There were predictions of a global economic meltdown.
At the bottom, the last desperate seller finally found the first courageous buyer. At the peak of the fear the low was reached. There was no one else left to sell in a panic.
Extremes in valuations occur over and over in all markets. For traders who buy the greed and sell the fear, it never ends well.
What do these events have to do with futures trading?
In early 2007, Warren Buffett was warning in public statements of excessive exuberance in the markets. He was cautioning traders and investors to be wary of the excessive amounts of speculation in the markets. Nobody listened. It was different this time — or so they said.
As traders, most of us have very little interest in these types of long-term booms and busts. We should, however, have a great deal of interest in the aspects of human nature that create them.
Unbridled greed and fear created the conditions leading to the boom and bust of 2006 – 2009. These same conditions appear in the futures market almost daily and are easy to find for those who know how.
How can futures traders find and take advantage of fear and greed?
Extreme valuations in long-term market trends can be easy to spot based on normal historic valuations. Warren Buffett sounded the alarm of extreme over-valuations in 2007 with his public warnings. The NYSE Trin index plays the role of Warren Buffett in the futures markets.
The Trin index tracks the overbought and oversold condition of a particular asset or market on a real-time basis. It displays for retail traders precisely when buyers have pushed the price too high or sellers have pushed the price too low.
Experienced traders simply wait for the correction of these conditions to get underway. Then they take advantage of the fear and greed of other traders to book profits for their trading accounts.
How can this type of trade go bad?
The housing market and the stock market were richly overvalued in early 2006. Yet the prices continued to soar even higher for another 18 months. Anyone attempting to trade the overbought condition too early would have seen their trading account decimated.
As we see over and over again, greed and fear can drive the market to extreme highs and lows. Then they can drive them even higher or lower. Prices regularly reach highs and lows far beyond what anyone expects or even believes possible.
If you enter trades too early, you might not be able to hold on until the market turns and the extreme conditions begin to correct.
In order to protect your trading account, it is crucial to wait until a correction is clearly underway before opening your positions. Using the Trin index over price chart is a great way to see corrections take hold.
Love what others hate and hate what they love
Warren Buffett famously said: “Be fearful when others are greedy and greedy when others are fearful.” He was talking about buying stocks. Trading overbought and oversold conditions in the market allows you to apply this sage advice to your futures trading. It clearly displays exceptional opportunities for high-probability trades.
It is a bit awkward to love what others hate while rejecting what they love. It takes some getting used to, but it is a very profitable trading strategy. If you are like most retail futures traders, making consistent trading profits might take some getting used to as well.
Now, please don’t think there is no downside to trading overbought and oversold conditions in the market. If you are not careful using this approach, you could wind up in a higher tax bracket.