While Foster credits Friedberg with giving him his start, it was trading legend Bruce Kovner who shaped his philosophy. “He basically said, ‘Always be very alert when sentiment diverges from price action.’ I took that to heart,” Foster says.
He says it would be wrong to assume this is a contrarian approach. Basically he is looking for a divergence between market sentiment and price action. If price is going down and sentiment is not, that is a bearish divergence, which causes Blackheath to sell short. “Conversely, if a market is going up and sentiment is not rising, those are positive divergences and that prompts us to buy a market,” Foster says.
He explains, “If the market is going up and people aren’t getting more bullish, it tells you, 1) there is not a lot of hot money in the trade and 2) commercial participants are probably selling into the market. That is a pretty strong market. Those are the kind of inputs that will put us into a trade.”
That begs the question: How does Blackheath measure sentiment? Foster has three approaches. He looks at numerous regularly published surveys on market sentiment, he studies the Commodity Futures Trading Commission’s Commitments of Traders (COT) report and he looks at anecdotal information. That simply could be news headlines or a more complex study of the options put/call ratio.
On the COT data, Foster looks at what the various participants are doing compared to price action. “If I see a currency go up and the small spec and CTA participation is not increasing, that is bullish divergence.”
While the program is not contrarian in nature, it has produced non-correlated returns to traditional trend-followers. It had its best year, 31.65%, in 2009, a difficult year for most CTAs. The strategy often catches people on the wrong side of the market who eventually will have to get out of their positions and move the market in their favor.
“In my fantasy scenario, at the end of the move people will say, ‘Oh my God, I am totally missing this market; I have got to get in,’ and then there is a stampede into the market. That is my opportunity to get out,” Foster says. “Buy it when people are ignoring it, and sell it when people are stampeding to get into it. It never works out exactly that well, but that is our cue to get out of the market, when sentiment finally catches up with the price action.”