Profiting from mass psychology

As a follow up to our last primer, I figured I should elaborate on a very short-term strategy I have found quite profitable in the past.  Remember that overwhelming majorities in financial markets must always be wrong.  This is one of the great paradoxes in investing and is why you should NEVER follow the crowd.

In my experience, identifying and then taking the opposite side of any overwhelming trade is easiest to do in the commodity markets.  Every Friday the Commodities and Futures Trading Commission publishes their Commitment of Traders report.  What I look for are net speculative long or net speculative short positions in particular commodities that are way out of whack with their typical averages.  In the case of Net Speculative Short positions, it implies that traders have actively shorted a particular commodity future.  To short something simply means that you have borrowed it with the promise to repay it later.  You then sell it in the open market and hope to repurchase it at a lower price to return to the person you borrowed it from.  The difference between what you sold it for and what you repurchased it for is your profit, assuming it dropped in price.  If you had to repurchase it at a higher price, you lose.  In essence, a short bet is made when a trader is convinced that a commodity will be worth less in the near future.

However, when massive short selling occurs, it becomes self-reinforcing as people selling to initiate their short positions introduce supply into the markets.  When a massive net speculative short balance exists, it implies two things:

1)  A ton of traders have already sold and are therefore on one side of the trade.

2)  It means that prices for that commodity will be volatile in the near term with a strong upwards bias.  This exists because any bounce to the upside initiates a round of short covering, as traders repurchase the commodity they shorted to limit their losses.  The problem is, as some traders begin to do this, it pushes prices higher forcing more and more traders to cover their shorts, becoming a self-feeding process to the upside.

Some potential instruments you can use to achieve the exposure to the necessary commodities are the HBP Bull/Bear double leveraged ETFs.  They are nasty volatile, but that can be a good thing if you catch the right side of a bounce.  I DO NOT recommend them as long-term investment vehicles.

I want to reiterate that this is a VERY risky investment strategy and can cut deeply if you end up ‘catching a falling knife’.  You should devote no more than 10 percent of your overall portfolio to this strategy, and I would recommend significantly less than that.  But, overall it has provided me with some nice short-term gains.

These net speculative imbalances don’t happen too often.  I might make 3 or 4 such bets a year and usually sell within a few weeks.  So don’t think that these opportunities permanently exist in the markets.  They usually occur when there is a ton of bad news about a particular commodity (such as natural gas right now), making it a difficult investment to make.  I’ve always found that the most profitable trades are the ones where you have to swallow hard, knowing there is no good news whatsoever about the stock or commodity you are purchasing.  But as they say, “the night is always darkest before dawn.”

This strategy looks to play on the volatility involved in group-think mentality.  It is not a way to play major speculative bubbles, which often take years to play out.  It’s always important to remember the words of John Maynard Keynes: “The markets can stay irrational longer than you and I can stay solvent”.

Cheers

B

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