Early in my career as a trader and even long before that as both
an investor and stock broker, I found it very difficult to successfully
outperform the stock market with my trades/investments. When I began my
career as a full-time trader, I was largely focused on outperforming
the market by out-trading the market (via the broad index tracking
vehicles such as the futures, options, and etf’s such as the SPY, QQQ,
etc..). However, I gradually learned that it was much easier, and
profitable, to focus on only trading the best looking technical patterns
on individual stocks and sectors vs. trying to successful game the
broad market.
Remember, every time you buy the SPY or go long the ES (S&P500
mini-futures), you buy the best performing stocks in the index as well
as the worst performing of those 500 stocks. You might be buying some
leading technology stocks when the tech sector is on fire but you are
also buying the worst performing stocks & sectors at the time as
well.
Ditto when shorting the broad markets. Even during a recession
or bear market, there are always stocks that do well, such as utilities
or other defensive sectors. When you short the SPY, you are shorting
some of the best capitalized, solid dividend paying blue chips stocks in
the world. In other words, you trade the good, the bad and the ugly….
all at once. Although trading the broad markets does provide the
benefits of diversification, it also puts a significant damper on your
profit potential.
Then why do I constantly post broad market commentary and charts? I
do so in order to align my trades, or overall market bias (long, short
or both), with the overall trend, or more importantly, what I expect the
trend to be going forward. As I like to say, one day does not make a
trend but I do think that this example does help illustrate my point. One of my favorite sectors on the short side over the last week or so
has been the biotechs, in particular biotech stocks that are listed on
the Nasdaq (Nasdaq listed stocks often tend to be more volatile and less
established than NYSE listed stocks).
As of the time that I made this chart (3:30pm ET), both the DOW &
S&P500 had gone positive on the day. Meanwhile, the IBB (my
preferred ETF for shorting the biotechnology sector) was down 2.34%. To
take it a step further, the 14 individual stocks that I recently listed as my
favorite shorts amongst the 116 components of the IBB were all negative
and down an average of 3.8%. My point is to illustrate that although
diversification in any portfolio, including a trading account, is
absolutely necessary, too much diversification can be detrimental, or
dillutive, if you will, to your overall returns even if your
charting/market timing skills are superior.
My trading style uses a top-down approach: Determine the overall
market trend or bias via analysis of the broad markets, then drill down
to select the most attractive (for longs) or bearish (for short) sectors
to focus on. From there, drill down to the individual components of
those preferred sectors or industries to determine the best looking
individual stocks within those groups. I believe that employing such as
strategy, whether trading or investing, is much more effective and less
frustrating than trying to beat the market by “trading the market”.
