Do the opposite
"Do the opposite" is a phrase you may have heard several traders say. But what does this expression mean? The answer lies in the intersection between financial theory, behavioral psychology, and general logical thinking
As I have mentioned in my previous article there are several different approaches a trader can have when he or she looking for current setups for trades. In book form, I have compared this to the choices a hunter has to make when hunting. Roughly speaking, as a hunter you can do three things. One is to follow a track to find a game, the second is to position yourself where you assume the game will come, and the third is to react lightning fast if a situation should suddenly arise where you are.
A trader does much of the same thing but uses different words for it. A common approach is to look for a trend (a trace) and take positions in the direction of this trend. Another is to monitor price levels where there have previously been, for example, peaks, troughs, or areas of large turnover volumes. If and when the market prices reach these areas, you can see how they behave and possibly find a good trade. The third method can be said to be action- or news-driven trading. In the market, some news will come suddenly (e.g. profit warning or notification of large contracts), while others will be announced in advance (e.g. presentation of quarterly figures). In both cases, there is new information in the market with relevance for pricing the stock, and by reacting quickly a trader can take advantage of this.
With or against
Financial theory predicts that prices in a free market will reflect "all available information". It is difficult to claim otherwise, but at the same time the prerequisites for this model are that everyone in the market receives all information at the same time, and that they are "rational" actors. The latter means that they act in a well-considered manner in line with their self-interest. These, too, are reasonable assumptions, which are mostly true. But there is often a slight difference between theory and practice. At any rate, we know that not all market participants receive and process all information at the same time, and it is also the case that what they choose to do depends on their starting point. Whether they are long, short or have no position ahead of the price-driving news is of great importance. Likewise, whether they have long-term or short-term (and perhaps leveraged) positions.
In the market, it is an established practice to release price-driving news outside the stock exchange's opening hours if possible. This way, everyone can have more time to look at the information and choose what they want to do with it. But this also helps to create situations that form the basis for the article's title.
A simple example is to think of a company that presents a surprisingly good quarterly result before the stock exchange opens. It seems obvious that the share price should open up. But then comes the question every trader must ask himself. Should this price jump be bought or sold?
The most reasonable answer is usually "it depends". And then there are usually three factors that are decisive.
1) What position did traders have before the price jump.
2) How big is the movement.
3) How the price behaves after opening with a jump up or down.
Point 1 includes everyone who had a position ahead of the price jump. Also for those who were not themselves in the share, it may be important to think a little about how players with active positions might react. Not least because this will be of great importance for point 3, i.e. how the share can be expected to move afterwards.
The interpretation of this also depends a lot on how the share and the market have moved ahead of the news. If, for example, the share and the market were in an upward trend and the price jump occurred in the direction of the trend, one can imagine that most people were long, and are comfortable being so also after the upswing. Then it will probably be a nice price jump, but little drama. If, on the other hand, the share has been in a trading range, been traded near the top of this, and takes a price jump through the bottom, the situation will be different. Then many people will perhaps be "wrong”, and a breach of the support level can result in a forced sale of levered positions and further pressure on the stock throughout the day.
It can be challenging for traders to deal with such news-driven price jumps. They may have spent time reading the news itself, and in addition broker comments and analyses. Based on this, one is convinced that the share will go up perhaps 10% and is prepared to buy. But then the share opens up at 12%. The entire assumed exchange rate effect is taken in stride. What do you do then?
You can often feel that the only thing you can do is the opposite. Go against both up- and down moves. However, consistently doing this is not a good idea. One must interpret the situation to decide what is most correct.
Quantitative and technical models
The mindset of "doing the opposite" is not only relevant in news-driven price movements. There are whole classes of technical and quantitative models that are based on this. "Contra-trend" or "mean-reversion" are terms that are often used for these. The background is just as logical as for the trend models: Excessive price movements are often corrected, and prices tend to move back towards an average.
The news flow in the market is also so extensive that it is almost impossible to keep track. Important news can be drowned in the flood of irrelevant noise, and it is not easy to know what can have a big impact. Then it might be a good idea for a trader to start at the other end. I myself always have a filter on the screen that shows unusual price and volume movements in the shares, indices and raw materials that are most important. Such a filter is an important tool both to see where there is "action" and to better decide where one should take positions.
Suppose, for example, that Nvidia, ticker NVDA is up 3% without any special news, but in a generally positive market. Is this reason enough to go short against the move? No. The filter will show that the normal intraday price movement for the share is in excess of 4%. There is then no point in going against such a rise before it passes the level of greater than normal. In addition, it is important to consider contextual information. The best set-up for a counter-trend trade is when a sudden price movement occurs early in the day, and it quickly takes the stock to test a technical support or resistance level.
Then it can be a good idea to "do the opposite".
Risks
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