EACH QUARTER YOU KNOW PRETTY WELL THAT INFOSYS IS GOING TO BE VOLATILE ON RESULTS DAY. LOGICALLY, IT MEANS THAT YOU SHOULD BE ABLE TO MAKE MONEY BY BUYING A STRADDLE OR A STRANGLE ON INFOSYS. IN REALITY, YOU RARELY MAKE MONEY ON SUCH OBVIOUS TRADES. YOUR ABILTIY TO CATCH A WINNING TRADE DEPENDS ON HOW QUICKLY YOU ARE ABLE TO CATCH A TREND IN ADVANCE OR HOW EFFECTIVELY YOU ARE ABLE TO BEAT THE CROWDS. IT IS ALMOST IMPOSSIBLE TO MAKE MONEY ON A TRADE THAT IS OBVIOUS WELL IN ADVANCE
OBVIOUS TRADES ARE OVERCROWDED TRADES
That is the typical feature of most obvious trades. Buying rate sensitive financial stocks ahead of a dovish monetary policy or buying agricultural stocks ahead of a rural oriented budget may appear to be a mug’s game. But in practice you will find such trades overcrowded. Take the last Union Budget 2018. Almost every trader and investor on the street was betting on the rural theme, especially after the sub-par performance of the ruling BJP in rural Gujarat. That seemed to be the most obvious trades. But, that is the trade that has hardly made any money as the trade got overcrowded even before the actual budget. At the end of the day, the budget did have a very strong rural focus and large allocations to rural infrastructure. But by then the trade had become crowded that most traders and investors found it hard to make any worthwhile money on these stocks. That is the downside risk of overcrowded trades.
OVERCROWDED TRADES END UP WITH NEGATIVE ECONOMIC PAYOFFS
What exactly do we understand by negative economic payoffs? When we talk of an equity trade, we are referring to the valuations getting quite rich well in advance. When we are talking about buying calls and puts, we are referring to the time value of these options becoming high enough to dissuade any profitable buying in the market. In case of futures, the premium over the spot price almost makes the trade prohibitive. Crowded trades create negative economic payoffs due to 3 reasons. Firstly, the demand for these trades far exceeds the supply. Hence the cost of these trades goes up substantially as we saw in the case of rural stocks. Secondly, the trade becomes skewed since most traders and investors are trying to play the trade on the same side and there is an absence of any counter trade on these stories. Lastly, a combination of round-the-clock media debates and analyst notes hardly leave any surprise element. That literally takes away the alpha trade and leaves it with negative economic payoff.
“If you want to make money as a trader then you must have the ability to buy on rumours and sell on news announcements” – Market Wisdom
6 WAYS TO OVERCOME THE CHALLENGE OF OVERCROWDED TRADES
- Try to be an early bird into any trade. For example, when the Gujarat elections concluded, it was quite obvious that the government would give the budget a rural twist. But the market started recognizing that only later on. The right time to take that trade would have been immediately after the election outcome. You would have had a lot of money on the table. Once the expectations were built across the street, the trade just became too overcrowded.
- Look at lateral beneficiaries. This is slightly more complicated. Take the case of Levi Strauss. During the Gold Rush in the US, Levi Strauss realized that irrespective of whether prospectors found or gold or not, they will still require rough jeans to help them in the activity. That is how Levi Strauss & Co. was born and it is a classical example of thinking laterally for opportunities.
- Don’t jump into an overcrowded trade. Once you are convinced about the worth of a trade, wait in the sidelines if you feel that the froth is too much. The moment the market corrects, you will get an opportunity to by these same stocks at more reasonable levels. That is the right time to enter.
- Once the trend is clear, look for the not-so obvious answers. For example, when the budget announced the National Health Program, most trades missed out the fact that diagnostic centres and insurance companies could be big beneficiaries. Most of these stocks showed a very strong traction in the coming weeks and held on to their gains despite the vagaries of the market. Try and focus on the less obvious stories.
- If you have the gumption, try to take the contra trade on an event. Take the case of the Union Budget 2018. Most traders saw the positive trade on rural consumption. What you missed out was that the higher fiscal deficit would push up yields and that will leave a big hole in bank balance sheets in terms of investment loss provisions. That story is really playing out now, although there are other factors too at play.
- Always try to assess who is crowding into any trade. Normally, we find the institutions and HNIs being the first to enter the trade. The retail investors tend to follow after that and that means they actually help in the distribution. Remember, nobody makes money when stocks are getting distributed. Try to run on the coat tails of the institutional approach to trades. That is a much better lead indicator of prospects ahead!
IN ANY OBVIOUS TRADE; TRY AND FOCUS ON THE NOT SO OBVIOUS
It is not that you cannot make any money on obvious trades. It is just that you need to look beyond the obvious. Look at contra trades; look at lateral beneficiaries and above all look at what the institutions and insiders are doing. That is worth its weight in gold!