Bubblelicious Margin Debt 3: Trading
Labeling a market a “bubble”, and the thought process that goes into deciding whether to apply it or not, is not entirely useless. Deciding that a market is in a bubble can be useful in helping a trader decide if they want to alter their trading and risk management strategies.
If a trader holds on to the philosophy of striking while the iron is hot, they might decide to take on more risk by increasing the size of their positions. While this may sound dangerous or downright insane to others, from the perspective of these traders, the highest returns are made when fear and FOMO are running highest in markets. As such, periods of collective irrationality in markets are when they take their largest risks, with the objective of earning the largest rewards.
However, this does not mean that such traders manage their risks poorly. While they may have a relatively high appetite for risk, they are cognizant of how quickly market conditions can turn, and manage their positions accordingly. For instance, they would adjust their stop loss levels closer to where the market is currently trading to preserve more of their profits in the event of the market making a sudden and sharp move lower. This, combined with their larger position size, increases their exposure to the market continuing higher, while limiting their potential for large losses should the bubble pop.
On the other hand, traders who are more conservative (those who would consider the first type to be crazy) may choose to take less risk in a market bubble. Their rationale being that the bubble may pop at any time, causing their profits to quickly become losses. Consequently, these traders tend to reduce the sizes of their positions when market conditions get too ebullient for their liking, or refuse to take any risk at all. Good examples of the latter include Buffett’s decision to sit out the NASDAQ bubble in 2000.
It is important to note that neither approach is “right” or “wrong”, nor inherently “better” or “worse” than the other. Every trader and investor has their own appetite for risk and tolerance for market volatility, and will act according to their own levels of comfort. What is important is that in acting with their levels of comfort, they are doing so with the full knowledge of the risks and rewards.
Should they choose to take on more risk, they need to be sure that the potential rewards outweigh those risks. While market bubbles may earn investors very high returns almost overnight, those same returns can evaporate just as quickly when the bubble pops. For traders who see bubbles as a trading opportunity, returns made on the way up must be preserved and not given back after the market peaks. As such, they need to manage their downside risk with vigilance and discipline – set a stop and stick to it.
Conversely, should traders choose to not take any risk, then they need to be aware of how much potential returns they are forgoing. Furthermore, they must be aware of the consequences of choosing to do so in an environment where markets are drunk on bullishness, and everyone thinks making money speculating is easy. This is especially pertinent to investors who manage other people’s money, as clients will turn on them for choosing not to participate in the bubble. For these investors, not risking capital in market bubbles morphs into another kind of risk – career risk.
Consequently, bubble or no bubble, it always boils down to risk and how one manages it in return for commensurate rewards. How are you managing your risk in this market?
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