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Sun Tzu and Dead Cat Bounces

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One of the things that happens to traders when they watch screens all day is that we are at times prone to losing long term perspective by watching short term price fluctuations. Depending on one’s trading style, a matter of moments can often seem like an eternity when having positions open.

Today, I was having a conversation with a friend who works for a small hedge fund in New York City on the dangers of having tunnel vision in current circumstances. Risk-off assets have performed relatively strong as of late, while risk-on assets have seen quite a meltdown. However, we cautioned ourselves against becoming too short after such a dramatic move.

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How Markets Work

What makes a market is a two-sided order opportunity, what creates volatility is both buyers and sellers coming to the market expecting an outcome. However, in some of the most severe sell-offs, there are often counter-trends moves that take place during the broader selling. In fact, a trend needs a momentary change of pace to keep a balance and broader direction intact. 

Looking over various charts heading into the end of the week leads me to some short term conclusions by remembering the larger picture at hand.

  1. While the COVID19 situation should be taken seriously and provoke international caution, at this point, the growth of the virus globally is remaining within the mean or average trajectory. What this means is that we have a better idea now of the pace the situation is escalating. While the growth is alarming, it seems that there will be fewer surprises at hand in the weeks going forward. We may be now positioned for good news as we wait to see how global quarantine effects contribute to slowing the growth of the pandemic, meanwhile every week that passes means we are closer to having some vaccine available.  
  2. Looking at the charts of various instruments shows markets at a near exhaustion point. No, I’m not calling for a top or bottom in any market, I’m just looking at the big picture and thinking some of these movements may be ready to take a breather even if a reversal doesn’t come. 
  3. The dead cat bounce, meaning a rally in a down-trending market, gives a lot of opportunities for an exhausted market to catch a temporary break. The counter-trend move can be rapid, allowing traders to enjoy fast profits. However, the nature of the dead cat often begins with smart money taking some profit and covering positions, and then momentum money jumping in for a quick buck or speculative bottom. After this, the smart money will often see a lift in a decaying market as an opportunity to short more at a better value.   

Plan Ahead

As you continue to watch the developing news and market reactions, you will be building your plan for the days and weeks to come. Sun Tzu says that wars are won or lost in the temple before they are ever fought on the battleground. I believe what this means for traders is that mental and emotional conditioning is our preparation for the future. When it comes to trading, we must keep aware of the larger picture. When markets do start reversing we must be prepared whether they are mere dead cat rallies or complete recoveries. 

For the most part, these are unprecedented times, we must leave our bias aside and be willing to adjust our thesis accordingly. 

Posted by Fair Value Trader on March 20, 2020
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