You are watching two markets: one is rallying sharply, it is in a clear uptrend; the other is choppy, it is rallying slowly. Which do you long: the leader or follower?
Intellectually your answer is probably: “I would long the strongest, of course.” However, for most of us, when we face real price action and the possibility of losing, our intellect may undergo a shift.
Fear often takes over, captivating you with the notion that the upside leader is poised to fall just as quickly as it has risen. The follower appears to be the safer choice. It’s moving slowly and may retrace more slowly, as well. This logic often prevails, leading traders to long the follower, expecting it to catch up or not fall, and watch the leader for clues.
The opposite is true for bear markets as well. Over the summer and fall of 2008, energy futures trended lower. There were days of sharp breaks and days of sharp rallies. Trading was volatile. Nevertheless the major trend was down. If you followed crude oil, heating oil and natural gas along with equities, currencies and gold, you had multiple choices to short. Choosing which market to short was the challenge. However, as it’s easy to be tentative on the upside, when markets break, it is equally tempting to ignore the downside leader and short a follower. Again, in trying to make a safe choice, you end up with the most dangerous.
Not surprisingly, over time the fearful response is the unprofitable one. When markets rise, you should generally long the strongest. When markets fall, you should generally short the weakest (and, maybe, both.) This advice is easy to say but is psychologically hard to put into action.
Consider the most popular futures contracts in the energy complex: crude oil, heating oil and natural gas. If you are a trend (position) trader or a swing trader, one way to trade the complex is to look at a six-month chart and see which contract is showing the sharpest movement. Sometimes one market will run sharply, while the others follow. There are times a former follower will become a leader. The idea is to constantly compare crude oil, heating oil and natural gas. Stay long the strongest in an uptrend. Stay short the weakest in a downtrend. When a new leader appears, switch to the new leader.
In “Oil spill”, crude oil was a good short. However, was it the best short? See “Gas leak.” Clearly, these two charts have the benefit of hindsight, but even taking them one day at a time you can see that natural gas was weaker from July to September, while crude oil was weaker from September through November 2008.
This helps demonstrate why, if you day-trade the energy complex, you must keep an eye on long-term direction. Trade what you see on an intraday basis, but trade in the direction of the sharpest run. Then go to cash and repeat the process the next trading day.
CAST A WIDE NET
If you are a single complex trader, you are probably aware of the other complexes and markets that can affect those you primarily trade. It’s often helpful to take that awareness to the next practical step, using the guideline of long the strongest, short the weakest. When a related market runs more sharply in the same direction as your primary complex, earmark a portion of your money and take a position in the run.
During the time period covered in this article, crude oil moved in the same direction as the S&P 500. Crude oil ran to the downside more sharply than equities and with less severe corrections (see “Weak yes, weakest no”). As an S&P 500 trader, you might have earmarked a portion of your money to short crude.
If you are flexible in terms of which complex you trade, then look for a leader wherever a leader appears. When an upside or downside leader emerges, focus most of your money on the leader. Shift your money when a new leader emerges.
Putting your money in the strongest individual market in a complex takes aggression. By going long the strongest and shorting the weakest, you are forcing yourself to be aggressive, but this will not, by itself, make you an aggressive trader.
Yes, you need to trade in a way that makes you comfortable. You also need to trade in a way that reduces your risk and increases your reward. Next time you see one market lead to the upside or one market lead to the downside, remember: long the strongest, short the weakest. You will trade more successfully. Perhaps more important to your long-term profitability, this forced aggression will ultimately become second nature.
That a market is an upside leader (or downside leader) is not changed by the analytics you use to track that market. The advice to long the strongest, short the weakest applies regardless of your analysis methods. It is a rifle-like approach to trading accuracy rather than a shotgun attempt at quick profits. It improves your aim, efficiency and success.
Richard L. Muehlberg uses linear regression channels and intermarket analysis to day-trade his own account. He publishes a day-trading diary on his Web site: www.DayTradingWithLinesInTheSky.com . E-mail him at firstname.lastname@example.org .