Buy the Fear, Sell the Greed: 7 Behavioral Quant Strategies for Traders

Let’s imagine you’re asking for professional advice on an important financial matter from someone who is experiencing the following symptoms:

• Nausea

• Dizziness

• Chest pain

• Headaches

• Neck aches

• Stomach upset

• Pulsing in the ear

• Burning skin

• Shortness of breath

• Electric shock feeling

• Shooting pains in the face

• Heart palpitations

• Weakness in legs

• Feelings of going crazy

• Fear of impending doom

On a scale of 1-10, how confident are you of this person’s judgment?

8-10 – Highly confident. This guy definitely has his act together.

5-7 – Somewhat confident. Maybe the shooting pains in his face and his heart palpitations are a bit bothersome, but you’re willing to overlook everything else, including his feelings of burning skin, nausea, dizziness, and the weakness in his legs.

2-4 – Little confidence. Feelings of going crazy and fear of impending doom are not quite the qualities that inspire strength and confidence in someone’s judgment in making financial decisions for you.

1 – None. Nada. Nul. Nicht. ZERO! The guy’s likely a nut. Who in their right mind would rely on the judgment of a person in this condition???

The Correct Answer

You likely answered either 2-4 or 1 (OK, I know you answered 1).

The Offer

Now let’s assume I make the following offer to you: I offer you the chance to trade directly against traders and investors who are having the exact symptoms listed above, including the feelings of going crazy and impending doom. And as a bonus…

1. You can trade one-on-one against them;

2. You get to determine the times you’ll trade against them;

3. You get to construct the trade however you feel is best for you;

4. And you get to do this multiple times every month for the rest of your life. On top of this you know that had you done this over the past quarter century, you would have won anywhere from over 70% of the time to up to 97% of the times you did this.

How does this make you feel? Would you accept this offer?

Most people certainly would and I’m sure you would too. This book is going to show you when, where, and how to do this.

So now I’m sure you’re excited. You’re also saying to yourself, “What’s the catch? This sounds too good to be true.”

Well, it’s true. You’ll see that quantitatively for years and even decades it’s been true. The catch is that the times you will be buying and selling these historically large-edge high-probability times are psychologically the hardest times to take these trades. This is why the edges you are about to learn have existed for years and, in many cases, decades.

Unfortunately, many traders and investors are psychologically unable to fully take advantage of these types of opportunities. (Warren Buffett can and does on the investment side, but this is a big part of why Buffett is Buffett.)

The outside fear when these trading opportunities occur is often too extreme and when fear is too extreme, the crippling symptoms mentioned earlier kick in and one normally goes into protection mode. Traders and investors are usually not willing or able to shut off the noise to go into offensive mode. You’ll see this throughout this book — there are many behavioral components going on at the same time and none add up to one rationally saying to themselves, “It’s time to buy.” In fact, the majority of rational people are in panic mode pushing prices even lower and making edges even greater for those who step in at the right time.

The goal of this book is to make you aware of when and why short-term market edges exist in stocks and in ETFs, and then give you the quantified strategies to trade them.

I wrote my first book on trading more than two decades ago and have since authored a half dozen more books. Each book contained either strategies and/or years of price data that showed where trading edges exist.

Over the past five years, it has become more and more apparent to me that the edges I saw were not being driven by technical analysis, nor fundamental analysis. The majority of the time they were being driven by behavioral factors of which fear and to a lesser extent greed were the catalysts. In a few cases, for example the RSI PowerZones Strategy in Chapter Two, we’ve seen these edges as measured by the times the signals were correct actually increase over recent years. Part of this is due to the 2009-2017 bull market. Another part of it is behavioral.

Thirty years ago, when a news event would occur, it could take days to assimilate it. The majority of the assimilation was done by professionals, not individual traders, who over time moved prices to where they should be. Fear and greed were certainly always prevalent, but outside of large events (for example, 1987), the response was smoothed by time and contained within a small universe, mostly made up of investment professionals.

Today it’s far different. News now drives prices every day, and at times every minute. The number of news sources today is vastly larger compared to 30 years ago. Thirty years ago, there was Dow Jones Newswires and maybe a few other financial news outlets. Bloomberg had only begun gaining some traction (I believe Michael Bloomberg had just made the decision to go into the news business) and CNBC didn’t exist, nor did the internet.

Today there are literally dozens of potential news and information sources for traders and investors to get their information from, ranging from Bloomberg, which is primarily for professional traders and investors, to many sites I won’t mention because there are so many, which get millions of pageviews a month because they put their own editorial spin to things. Add in CNBC, which runs before and during market hours and is followed by (as of May 2018) Fast Money, which moves stocks after hours, along with the ubiquitous Jim Cramer coming on the air right after with his hour-long show, plus dozens of message boards including the large user-generated content site StockTwits, and the news and chatter never shut off.

If fear is a contagion, then when fear hits, it quickly goes viral. Nearly two decades before D-Day, then-Major George Patton so astutely pointed out that human nature in soldiers (and I believe he likely meant all humans) never changes. The same can be said for traders and investors. The only thing that’s changed is the timing of their emotion; today it occurs faster and at times is more extreme primarily due to the role the media (and especially social media) plays in disseminating the news that triggers this behavior. We’ll see this played out and quantified in each of the strategies in the book.

We’ll start the book off with two chapters, with one that shows when fear is at its greatest and has correctly predicted the short-term direction of liquid ETFs over 80% of the time since 2006. For the S&P 500 ETF (SPY), the strategy has correctly predicted its direction over 91% of the time since 1993.

We’ll then look at a strategy that takes advantage of greed; in this case it’s extreme greed in stocks where the stocks reach parabolic levels, often because of news and crazy rumors, and then they reverse (they CRASH) the majority of the time.

From there we’ll go to my favorite topic: trading volatility via VXX. No market gets inside fear better than the volatility market, and we’ll walk through the history and, more importantly, the structure of VXX, where we’ll see why and how this product was built to go to zero.

We’ll also look at the five types of buyers in VXX, a group that has historically lost substantial money year after year since 2009. They range from well-meaning but uninformed investment advisors all the way to outright gamblers. With this knowledge, we will then learn two strategies to trade this structurally inefficient product, one that applies a very short-term time frame (on average approximately one week) to a longer-term trend-following strategy that climbs aboard being short VXX on average for three months while VXX trends lower. There are strong historical test results in these two strategies and these edges have been in existence since VXX was created and brought to the market in early 2009.

We’ll then look at the Trading New Highs Strategy, a strategy we created based on a seminal academic study that was originally published in 2004 and is still often referenced today. This study shows how traders and investors use New 52-Week Highs as an anchor point. We added a fear component to this anchor point and you’ll see that when combining their findings with fear, those stocks have risen over 77% of the time within days.

Chapter Eight looks at the times fear and greed build up in equity indexes, not only in the United States, but around the world. Applying a scaling-in approach, this strategy has correctly identified prices moving higher well over 80% of the time. This strategy is robust, meaning there are literally thousands of permutations you can apply to buy fear and sell greed in ETFs.

Chapter Nine looks at overnight fear. This strategy combines taking an ETF that has been pounded down by incessant selling and then gaps lower. Then a further intraday sell-off creates panic and terror to the owners of these ETFs. The majority of the time, many of these owners can’t take the pain any longer (they exhibit a number of the symptoms we talked about earlier) and they sell out of their position in order to avoid any further pain. You’ll learn to step in and take the position from them, oftentimes with large edges in place.

Then we’ll tie everything together, including looking at how closely this type of trading resembles Warren Buffett’s type of investing. Buffett has made a fortune from “buying fear.” He has had a repeatable process in place — often buying when everyone else is selling. On a longer-term basis you’ll see how Buffett has done this for decades with these investments. We’ll tie together these same behavioral biases and doing so on a short-term trading basis. We’ll also discuss the many ways to take these strategies and apply them to your trading.

In the Appendix, you’ll gain further knowledge with additional resources I recommend that are available to you, along with additional ways to structure your trades to buy fear and sell greed. By the time you’re done with this book, you’ll be able to move ahead, quantitatively applying behavioral edges that will likely be in place for many years to come. Markets may change but, as you will repeatedly see, human behavior does not.