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Monday, October 3, 2016
"What do you look for in a trade?"
It was one of the questions people asked me the most at our Stansberry Conference in Las Vegas.
This question came in all kinds of variations...
So today, I thought I'd briefly run through my thinking by using an example...
I will tell you what our example is later. But for now, it's easier if you start by looking at it objectively.
Let's look at this investment... What do you see?
I see a multiyear downtrend that accelerated in 2014-2015 and finally ended in late 2015. The price fell from around $25 to around $11.
Since then, we've had a strong uptrend – this investment has doubled from its bottom in a little more than a year.
The downtrend was clear, and the current uptrend is clear. (There are plenty of complicated ways you can define uptrends... But I urge you to not worry about that so much. Eyeballing it is actually good enough for our purposes. The important thing is that you want the uptrend to show that the market is confirming your "thesis" about this investment.)
So we have an uptrend... But what now?
This investment has roughly doubled in a year... Is it time to worry?
Let's find out...
First, I check the sentiment on that investment...
I want to see if investors are overly excited about this investment. The reason why I check is simple: There's typically not much room for upside potential if investors are overly excited and everyone is already in the trade.
If investors are overly excited, I either stay away or seriously tighten my trailing stops.
So how do I check the sentiment? Sentiment is challenging to put into numbers. In this case, this investment is a commodity, so I start with my two favorite indicators for commodity sentiment... the Commitment of Traders report and SentimenTrader.com's "Optix" sentiment gauge.
Bingo! In both cases, we're sitting at either all-time highs or decade highs in investor optimism.
Based on these two numbers, I don't need to go any further. I know what I need to know.
I will avoid this investment, even though it's in a strong uptrend. Why?
Because the downside risk is greater than the upside potential at this point.
Here is this investment (on top) versus the Commitment of Traders (on the bottom). What do you see?
Here's what I see...
Traders are overly "committed" to this investment right now – to a record degree. "There's nobody left to buy," as they say. And when there's nobody left to buy, the downside risk is great.
Without even knowing what this investment is, I can tell you two things:
Would I bet against it? No... not yet. I don't want to fight the uptrend.
If you were wondering what asset we're looking at, it's sugar.
That's how I'd size up the trading opportunity in sugar right now.
If you want to know how I quickly size up a trade, that's it... That's my starting thought process.
You can make it a lot more complicated than that, but to me, that's a waste of time. Within two minutes, I knew everything I needed to know – which is that I'm not interested in digging deeper into buying sugar at this point and that my time would be better spent finding a better trade setup.
"Is everyone optimistic about stock prices? Is everyone 'in'? Is everyone talking about their 'can't lose' stock strategies at cocktail parties?" Steve recently wrote about the importance of sentiment in the markets. Learn how to recognize these extremes – and what they mean for your investments – right here.
Understanding whether or not you should buy a stock takes time. But before you dig more deeply, there are a few key questions you should ask yourself. "The wrong answer to any one of these questions is a sign you should look elsewhere," Kim Iskyan writes. Read more here.
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