How I profit from Market Psychology

In the recent bull rally over the last half year, I bought the three dips I circled here in perfectly timed fashion:

receipts:

Let me walk through the market psychology behind each trade:

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August 5th:

This was the Monday morning after the futures markets capitulated on Sunday evening. This was the most violent correction of the year, and many people decided to buy at the Friday market close thinking the weekend would give the market time to calm down. They were wrong.

As a long time market maker, I have seen these panic moves often, and when the market maker gets squeezed and can’t quote markets anymore, and the algorithms turn off for safety reasons, that’s been the bottom about 70% of the time in my experience.

My understanding is that whatever combination of conditions forcing the market to waterfall is finally broken in these situations, and the fresh reset allows a more macro force to dictate the direction back upwards towards longer term trend lines.

A more “market psychology” explanation is to simply say that the market puked and can’t puke anymore. When each day the selloff gets bigger, and it finally culminates in the biggest sell off, and markets widen out and algos turn off, that’s the market dry heaving. Keep in mind that this only applies to cases where there’s no actual macro news (as was the case here).

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September 6th:

The market has a strong V shaped recovery in the last month, but the entire market is acutely aware of how scary the correction was, and is wondering whether we’ll see a retesting of those recent lows. Is this simply the first leg of a bear market bounce?

We start to see a similar pattern unfold as the market begins to slide multiple days in a row again. Everyone in financial news is talking about the move from last month which culminated in the biggest and scariest move on Sunday night where it capitulated. This is exactly why I bought on the Friday. The market is deceptive and usually punishes an emotional thinker. Only a fool would buy on Friday when everyone remembers the last Friday after multiple selloffs led to the market collapsing on Sunday. Right? Wrong. If only a fool would buy there, and 95% of retail traders lose money, it is +EV to buy there because I am acting opposite to a retail trader.

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October 31st:

This is an easy one. Markets dipped a few days ahead of the presidential election on Nov 5th. As I mention in my politics video, I felt strongly that Trump would win. In 2016 his win led to one of the strongest post-election rallies I’ve ever seen. Everyone knows Trump loves deregulating and turbocharging the stock market so there’s no reason to think the market wouldn’t react the same way again. I bought this dip and it paid off.

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Summary:

Now I don’t claim to get every dip right. Some dips can evolve into the beginning of a longer term bear market, but the relationship between the market and the news cycle is different in those cases. These dips weren’t correlated with heavy macro news events. In fact, there was nothing happening in the news during most of these mini-crashes. So these dips were a result of market participants behaving irrationally, or as I like to theorize, it was part of a required purging process to prevent simplistic traders from making mean-reversion bets on the vix.

You see, the vix has to have some violent pops from time to time to ensure that there’s no easy free lunch in making mean-reversion bets on it. This is similar to the concept of “stop loss hunting”.

When it’s likely that the market moves are based on these games and not actual economic fundamentals, it is likely a good time to bet on that move reversing.