Always Trade Value

Always trade value is one of the 10 Irrefutable Laws of Trading Success. The 10 Irrefutable Laws of Trading Success are 10 laws that I have seen over 30 years of trading and back testing and going through data. These 10 laws or 10 laws that I have seen that have held up over time. That when I go through and it doesn't matter the asset class, it doesn't matter the timeframe, these laws tend to hold up, they tend to show statistical significance. Today we're going to talk about number seven, which is always trade value. Buy low, sell high, and use positive reversion to trade. Let's get into it. If you'd been watching the videos I did this week. One of the things that I've been talking about now for about a week was that I thought that we were at a point where NVIDIA was putting in a high, that NVIDIA would top. Now NVIDIA has been a hot stock of 2024. It's basically gone parabolic since the beginning of the year, but through the concepts that we talked about through these 10 laws, and through the techniques and the indicators that we've built, NVIDIA is becoming really really overbought, overbought and an unsustainable way. There's overbought, and then there's overbought that's unsustainable and this is what I had been talking about with NVIDIA for the last 10 days. Well, if you saw what happened to NVIDIA today, it was down big. It did come back some late in the day, but now you can actually start to see a top coming in. Now even we have earnings tomorrow for NVIDIA, so that could change things. But I actually believe that NVIDIA is starting to either put in a range or to revert and go lower. This is actually gonna be a great conversation for this concept today. 

Let's get into it. One of the things they always say is people talk about mean reversion, but they actually don't quite understand how mean reversion works. The market always reverts to the mean. It always, always, always reverts to the mean. The question is, what type of reversion is going to be? The mean reverts two different ways, when people think of mean reversion they think of number one, which is price reverts to the mean. This means the market gets really overbought and then the market collapses and goes back to the mean, prices fall or prices rally if the markets been breaking so the price goes back to mean. The second way is the way that people don't talk about and that is that the mean catches up to price. What this means is the market may be overbought, but then it goes sideways for a long period of time waiting for the mean to catch up. When the mean catches up, then the market starts to go again. This whole concept of the mean and trading around the mean and how prices move around the mean, lends itself to cycles. Now, there's cycles out there that, frankly I think are bullshit. But there's some cycles that we do use and the cycles we use really revolve around this concept of the mean and the concept of mean reversion. It's important to understand both of these patterns and their implications and how we manage prices. If we think we're going to revert by going back to the mean, well, that's one behavior and we manage it one way, if we think that the mean is going to catch up, we manage it in a different way. But understanding these two ways gives us a better sense of how to manage trades. 

Now we mentioned this concept of positive reversion what is positive reversion? While we're talking about mean reversion, positive reversion is when you buy below the mean and you sell above the mean and the market making realm, market makers are always talking about trading for edge. They have some type of model, they have some type of theoretical value that and then they buy below that value, and they sell above it and they try and do that as many times as they can. Every time that they can buy below fair value. They've collected an edge, the difference between what they paid and what fair value was. When they're able to sell above fair value, they collect an edge, the difference in price between where they sold it and where fair value is. When we have positive reversion we're buying below value selling above value. Negative reversion is just the opposite, in negative reversion, we buy above value, and we sell below value. We're actually giving up an edge. Again, in the trading realm, market makers tend to get edges to trade. They buy on the bid and they sell on the offer and the customer, like you the customer to be able to execute your trade you need to buy at the offer or sell at the bid, so you give up a small my edge. Everybody talks about what they spend in commissions, but in a lot of cases the edge you give up in reversion is oftentimes much bigger than the commission. That's a topic for another day but one of the questions you want to ask yourself is are your trades positive reversion trades or negative reversion trades? Most traders have no freaking clue what they do or which they are. 

When we understand this, we understand that we're trading around value. This trading around value is a really important concept because this makes sure that you don't overpay. This makes sure that you don't sell in the hole. When you look at professional traders, they're always fighting for the execution. They're always trying to buy as cheap as they can sell as rich as they can and that's because they know that if they can buy low, sell high, they'll make more money. Now there's exceptions to this, but in general, this is a case. We'll come back to that. This is a schematic from a book I absolutely love called Alpha Brain by Stephen Duneier and one of the things he shows is that when you have a fair value, and we use positive reversion, what we want to do is we actually want to sell, if we're long and values going higher, we want to sell just inside the upper band of fair value. We essentially have a fair value band, we have fair value in the middle and then we have statistical bands on either side, a statistical sell band a statistical buy band, so we sell just inside of the statistical sell band, and we place our exits just outside, our stops just outside the statistical buy band. So we use this expectation model around fair value to make decisions of where to buy and where to sell. 

Now, I've been mentioning NVIDIA, let's look at NVIDIA. There's lots of discussions we can have about what is the mean. Okay, what is the mean? Well, the mean is subjective and we have several classes that we teach just on understanding the mean and how prices move around the mean. For tonight, one of the things I can tell you is you can adopt something simple. In this case, we're just using a 10 period volume weighted moving average, a 10 period volume weighted moving average. It's very simple, it's in every charting package, and that's this green line. One of the things we can say is Well, this is our mean. So if we're above it, we're above the mean, if we're below the 10 period volume weighted moving average, we're below the mean. Right? If so, reversion to the mean would be if we get above it, we go back to it. You can see, if we get below it, we go back to it. We get above it, we go back down to it, you can see were the markets oscillating around this mean. Now, when we get into a trend like we did here, when we get into a trend, the market can stay away from the mean for a while, but it cannot stay away forever. So one of the things I want you to notice here is NVIDIA brakes out in January on the strong breakout right here, and it's running higher, higher higher, but notice it's getting nowhere near the 10 period. Now up in here you see it runs, you can see we have 1, 2, 3, 4, 5, 6 candles in a row that overlap. We go into many trading range and while that's happening, you see the 10 period catches up. At this point we revert to the mean and off the market goes again. Okay, so and I've been talking about NVIDIA putting in a top for the last week, really starting in here and you see it's gone sideways since and then had a down day on Friday, big down day today. 

One of the things we need to be aware of is where's price relative to the mean? People are unaware of this. So because of this, they're not aware of value, they have no value framework. You need to have a value framework for all of your training. You need to understand what value is so you know if you're buying it cheap or too expensive, and in this case, NVIDIA has gotten too far from its mean. It's set up to revert back and you can see well today and now we went back to its 10 period of crash through it, went all the way down to its 20 period. We want to understand this. I talked to people last week, about NVIDIA specifically talked to some analysts and everybody I talked to, everybody I talked to was bullish. Now in their mind, part of their value framework is they think NVIDIA is worth a lot more because of its earnings. But I looked through my statistical framework and I just knew it was in a run that was unsustainable and sure enough, when you can't find anybody who's bearish markets probably gonna go lower. Why? Because you're out of buyers. For the market to go up, you need buyers. If everybody's bought it, there's no buyers left. So the market is going to have to go lower to be able to find new buyers. So where are you at? on this? Do you have a value framework? Are you aware if your trades are positive reversion or negative reversion? You need to be able to answer these questions. You cannot be a pro, you cannot be a great trader and not be able to answer these questions. All right. So that's gonna be a wrap for today. This is Trader Tip Tuesday, where every Tuesday I come to you with different techniques, different concepts, different principles, like today, to help you take your performance to an elite level. See you next Tuesday.