Trading psychologists generally agree that there are two dominant emotions in the area of behavioral psychology that influence market price and performance. These two emotions are fear and greed. It is also generally agreed in the scholarly literature that fear is about three times more powerful than greed. It distorts our normal rational analytical mind when it comes to considerations of reward and risk.
Knowing this fact, a short term trader could reasonably conclude that market mispricing occurs more likely in moments of great fear that great greed. A short term outlook is much more likely to be influenced by emotion the longer-term rational approach to the markets.
For these reasons, a short-term trader could consider the idea of “Max Pain” in the search for tradable short-term opportunities.
Here are some different ways this idea could be used to find low risk tradable ideas.
- Become familiar with a small set of liquid companies and ETFs and determine what normal conditions of gains and losses are. Then, be on the lookout for moments when losses have exceeded the threshold of normal. Use these moments as opportunities to find high probability reversion to the mean trades.
- Become an expert in a single stock or ETF and develop an appreciation for how it trades in normal swings in short term time periods and look for moments of exaggerated selling with respect to the recent normal behavior. Chances are you have identified an overreaction on the sell side which may afford you an opportunity to revert to the mean.
- Pay close attention to the size and direction of the morning gap in a set of tradable instruments. Find those symbols that have lost the greatest percentage from yesterday’s close entry fees, and treat them as high probability candidates for reversion to the mean. Look for them to find support in the first 30 minutes of the market and prepared to go long with a tight stop. Even if these symbols only close the morning gap you may have made your daily profit objective in the first couple hours of trading.
- Look for adverse reactions to news events that take the market by surprise. Chances are that panic selling will miss price a reasonable company and create a moments of by value at a discount.
The idea behind this “MaxPain” strategy is that you avoid the sudden surprise losses that created the opportunity, and you are positioned to play for the rebound. This is definitely a short-term strategy for one of which happens with such regularity you may find it a valuable addition to your trading arsenal.