XLE Stock: Being Right to Be Wrong (NYSEARCA: XLE)
There are about ten thousand ways a business idea can go wrong. You don’t need to trade very long to seemingly encounter most of them on your first handful of trades! The goal, of course, is to manage behavior and reduce all of these possibilities to a few scenarios and cases that will result in consistent trader action.
Back to a trade idea: shorting XLE
At the end of last week (9/30/22) we were looking at some very good short setups in energy stocks. Now we knew these were potentially problematic trades. Energy has been a clear leader since the first quarter of 2020 and at various times has been more or less the only sector that has supported the market.
This type of industry leadership tends to be persistent, which means betting against it is usually a losing proposition. Yet leadership rotates, and former leaders (Tech, for example) often abandon that leadership with volatile meltdowns.
So we knew we were coming up with a business idea that would be… to put it mildly… not boring! It was reasonable to expect a quick resolution in both directions.
The best kind of failure
Most of our trading over the past few years has involved trading consolidations (flags, ledges, triangles) within trends, or at structural points where trends might begin. I’ve literally written hundreds of thousands of words about these patterns, but let’s focus on one clear advantage: if you enter them correctly, you can often dodge losing trades with no loss.
It just means waiting for a breakdown to come in. You can set the pattern boundaries with a trendline, with pivot points, with shorter period patterns – a lot of things work, but you need confirmation of price movement outside the pattern to trigger you in a transaction.
Once you are there, you need momentum confirmation to hold the trade. The easiest way to do this is to just watch the end of the bar that allows you to enter the trade. If that close shows strong momentum (in this case, weakness), then you hold the trade. Otherwise, you leave.
The most important mental skill for success
This strategy will result in small wins and losses that more than offset each other (but maybe not completely). However, if you are not disciplined and hold on to some of the losing trades for too long, you will rack up large enough losses to do damage, which brings us to the key skill: flexibility.
“Strong opinions, held every week” is the motto that drives us. As a trader, you take significant risks – it’s not that every decision is life or death, but our decisions have serious consequences. Make the wrong decision and you can lose everything you own…and, for too many traders, it has been life or death.
So, to have the courage to intervene and take a stand, you need very strong opinions! If I’m wrong, I’ll lose money, and if I’m wrong and I’m stupid, I could lose a lot of money. But the real secret is in the “loosely held”, and it is a most unnatural thing for humans.
Think of all the fervor for politics and Covid we’ve seen over the past year. How do people typically handle disagreements? Normal people dig deeper, seek confirmation, and ignore (or explain away) evidence that contradicts their views. Separating someone from their opinion is often almost impossible!
This is how normal human thinking works, but traders have to be different. Traders must be prepared to hold a very strong opinion – the strongest in the world, perhaps… the most certain – and to change it instantly when the right information contradicts that opinion.
Negotiate consolidations with flexibility
And this little business idea is a great example of that. Over the weekend we loved the index pattern – we spent quite a bit of time looking at probably a hundred individual names and were ready to pick out the best examples by early Monday morning. We thought about how to hedge the trades, how much correlated exposure we were comfortable with. In short, we were all on this court.
And what happened? On Monday morning, the XLE (and nearly every stock in the sector) widened with a very big gap.
We simply couldn’t have been more wrong had we tried – the shorts were perfectly, exactly, almost beautifully wrong. So what did we do?
Absolutely nothing. The P&L impact of this staggering failure was absolutely zero – no trades were entered as we had no breakouts on the downside, and certainly no confirmation. The market didn’t care about our opinion or how much time we spent developing solid trading ideas.
It started as a blog on how to trade a technical pattern. And this is important: if you are trading consolidation patterns (and I think most traders should be!), enter with a breakout of the pattern, exit bad trades and only hold with confirmation momentum . It’s a simple lesson, but I think the psychological skills needed to turn that lesson into consistent behavior are not so easy to grasp.
You will trade wrong, and often. With some types of trading, you will be wrong about half the time. It’s okay to be wrong – but to stay wrong…that’s the problem. You have many choices in trading, and the choice to lose your opinion or your money is the one you will be presented with repeatedly.
Make the right choice and you can build a fortune. Make the wrong choice and you won’t be a trader.
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.