Emotional Roller Coaster

They don't make it easy on the short side.  It has been a roller coaster ride since the island top made on July 16.  For shorts, in order to catch most of the down move from mid July to early August, you had to withstand an 80 point drawdown on day 4-5 of the selloff, and a 160 point drawdown on day 11-12 of the selloff.  That face ripper on July 31 on FOMC day truly tested the mettle of the bears.  It looked similar to a lot of the past V bottoms you've had over the past 15 years.  On that Wednesday, you had a lot of BTFD conditioned bulls shouting bottom on that day, and it shook the conviction of a lot of bears.  

I must admit, I was getting a bit nervous there, as the overshoot towards SPX 5560 made it look like a V bottom.  It was definitely not according to plan.  You can thank short term FOMO buyers and short term options flows for causing such a huge squeeze in the middle of the biggest down move this year.  Thankfully, that face ripper reversed quickly, because there were some doubts that were creeping in from past scars of being short after a V bottom. 

After a face ripper like that, it is natural to want to cover your short quickly afterwards on a selloff, to avoid that pain again.  Or if you were long, to just hang on during the ensuing selloff so that you can catch another whoosh higher.  

With all the spastic short term options trading these days, you get these ridiculous overshoots that can really test your nerves.  There are positives to the options flow.  If you are selective with entries, you can get great prices to enter either shorts or longs into the overshoot.  You saw that on Monday as the longs puked out their positions, which was reinforced by gamma and vanna forces in options as vols blew out.  Of course, you have to be ready to catch those overshoots by having pre-determined levels where you want to buy or sell. 

After the violent moves of the past several weeks, it shows how important psychology is in this game.  You had the relentless up move off the April bottom into the euphoric July top, where bulls were celebrating and shouting while the bears were getting crushed and despondent.  Then the sharp reversal which destroyed a lot of late to the party bulls and rewarded the timely bears who stuck with the fundamentals and data. 

The analysis is the easy part, going through the ups and downs when you have your own money on the line is the hard part.  The markets are much more a psychological test than an analytical one.  A slightly above average market forecaster who has a good psychological game will be a better trader and investor than an excellent market forecaster who is undisciplined, and falls for the temptations of locking in wins quickly and hanging on to the losers hoping they come back.  

In order to survive in this game, you have to be more like a gambler than a salaryman.   Gamblers enjoy the stress and tension of making a bet and riding the ups and downs.  Salarymen want regular wins, at regular intervals, and get stressed out experiencing the ups and downs of holding on to volatile positions.  The world of trading is not designed for the salaryman mentality.  No trader wants to be considered a gambler, but the financial markets are a glorified casino.  It fits those that are comfortable with volatility and risk.  Of course, too much risk is just asking to get blown up.  One has to ride that fine line between taking enough risk to get meaningful returns, while not taking too much risk which leads to blow ups.

There are many failed traders who go on to selling subscriptions to have a steady income and avoid getting a real job.  Psychologically, its much easier to sell subscriptions and have that be your main source of cash flow than it is to rely on speculation as your sole source of income.   Trading on the side as a part time pursuit with a full time job or with subscription revenue is not the same as having all your income based on trading.  That's why you see so many traders come and go on Twitter, but the sub sellers are always there.  Selling something. Trading as a profession has to be one of the lowest success rate endeavors out there.  They say 8 out of 10 businesses fail.  I would guess that more than 9 out of 10 traders fail. 

Speculating is stressful, and it lures traders to try to maximize emotional comfort.  This leads to overtrading and wanting to reduce risk quickly when winning.  Its human nature to want to hang on to losing trades, hoping they come back.  And its human nature to want to get out of winning trades, fearing that the gains will be given back, and to book a win.  Its not natural to hang on to winning trades, hoping for bigger gains.  That’s why I like to put on price targets for trades, in order to have a goal for the trade.  Its a psychological tool for staying in winning trades, to ride them out as planned.

When you are holding a big position, there is stress and tension that only gets relieved once that position is completely closed out.  The psychological temptation is always there to close out that winning position, to relieve the tension and reduce the stress, to give yourself the win.  That temptation is much weaker when holding a losing position.  While closing a loser relieves tension and reduces stress, you are also locking in a loss, admitting to losing, which most people naturally hate to do. 

Back to the market.  Monday was capitulation.  It came a couple of days faster than expected, but its hard to get both price and time correct.  At least the price targets were hit, and it went beyond expectations.  That is what happens when you have so many leaning on one side of the boat and it starts to tip over.  Panic ensues.  People will talk about the unwind of yen carry trades and CTAs and vol control funds dumping their positions, but it all comes down to speculators overexposed to the long side, with very little put protection, feeling intense heat as the market went against them in a hurry.  

A look at the COT data as of July 30, when the SPX closed at 5436, a 230 point drawdown from the top on July 16.  Normally, you would see a lot more positions being unwound by the asset managers and speculators, but that's not what happened.  Net longs remained elevated. And dealers remained very short.  

 

 

It will be interesting to see what this coming Friday's COT report shows, which will cover what happened during the selloff from Thursday to Monday.  It should show heavy reductions in the asset managers and small spec long positioning.  

On Monday, and to a lesser extent on Friday, we finally got the put buying that this market needed to at least start the bottoming process.  Given that its really only just starting, and there was so little put buying during the previous days of the selloff, I would expect it to continue througout the week.  

 

Given the massive move higher in vol, and the psychological damage of such a volatile drop, I don't think Monday was the day that we made a V bottom.  Based on previous vol explosions like August 2015 and February 2018, we should see a retest of Monday's lows in the next few days.  Those lows will probably hold, and you can have a 2-3 week rally which would suck in the bulls again, but they will have much less enthusiasm this time, meaning that I doubt you can get back near the July highs anytime soon.  

 

SPX February 2018

 

SPX August 2015

Covered all my shorts on Monday.  Did put on a small long position in SPX and NDX, looking for a gap up and a 1 day bounce.  Which is playing out.  I will likely close out this position today and may even put on a small short position, looking for another move lower this week to retest the Monday low zone around SPX 5120-5140.  After Monday's capitulation and liquidations, the market is now buyable for a trade, on weakness, and will favor a range trading strategy, rather than a bull or bear strategy.  There should be many opportunities on both sides for the next 2 months.  This is the time to make your points and be on your game.  These kind of trading markets don't last for long.  Take advantage of it while its here.