Wednesday, November 11, 2009


I often see traders trying to pick a top. It's a favorite pastime of bears.

But I have to pose the question is it really worth the trouble? I think when I'm finished you will see that it not only isn't worth the effort but is actually one of the single worst strategies anyone can choose.

Picking tops is actually the bread and butter trade of Moe Ronn (our fictional character representing the average retail investor).

Let's say Moe thinks the market is due to top out and roll over into a bear market anytime based on his interpretation of the fundamentals (either real or imaginary it doesn't matter). So Moe decides he's done with the long side of the market and he begins shorting in an attempt to spot the top. He makes repeated attempts to short taking multiple small losses while he waits for the expected turn.

Now let's say Moe finally gets lucky and shorts XYZ stock at the exact top at $100. Let's also assume that Moe manages to hold on through the extremely violent whipsaws that almost always occur as a bull market slowly rolls over. (This is a huge assumption but just for the sake of argument we're going to give Moe this one).

Let's also assume that Moe manages to exit his short at the very bottom with XYZ trading at $20. Moe just earned himself a very nice 80% return minus however much he lost trying to pick the top.

That's how the Moe Ronn's of the world trade.

Now let's see how John I. Que goes about trading a bear market. Let's say John also thinks the market is due to roll over into a bear phase and he too wants to short XYZ. First off John doesn't attempt to try and spot the top. He knows that is a fools game. John just goes to cash and waits patiently for a sign that the bear has truly returned.

Eventually XYZ rolls over and sinks below the 200 DMA. By this time XYZ has lost $20 already. At this point John is confident we have now entered a bear market and he sells short XYZ. John also manages to exit his short close to the bottom at $20. John just lost one hell of an opportunity because he was late to the party, right?

Not quite, the opposite in fact. Consider that the drop from $100 to $20 was an 80% gain for Moe's short. Not bad, not bad at all. But the move from $80 to $20 was a 75% gain for John's short. John only gave up 5% by waiting till the bear clearly declared itself and in the process avoided the many false starts that Moe had to suffer through in trying to pick the top. In reality John most likely made more money by missing the top by $20 than Moe did by timing it perfectly.