The markets are always full of crowded trades. Whether it be in a stock, exchange-traded fund (ETF), exchange-traded note (ETN), bonds or cryptocurrencies, sometimes too many people get into the same trade. Market participants everywhere are pile into stocks with little concern of being on the wrong side of the trade.
Some traders tend to have the thought, “The rest of the world is buying it, so why not me?” The same goes for when people are short. Our community likes looking for crowded trades, and taking the opposite once they start to crack, and this is all with “defined” risk. That said, there are some signals of crowded trades, and if you notice them, you should approach with caution.
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Crowded trades could be dangerous
Who could forget the extreme move in the cryptocurrency market. There were plenty of people getting into Bitcoin near the highs, thinking it could continue higher. These investors thought so many people who got in early were getting paid, so they could do the same. Those who bought above $15K are now kicking themselves because they lost half their investment. A plethora of analysts projected Bitcoin to hit $50K, some even went as bold to say it could hit $100K in a short period. Although it could happen, you only care about your current profit and loss (PnL).
Here’s a look at Bitcoin/U.S. dollar (BTCUSD) on the daily chart:
Heck, who could forget the infamous short volatility trade? A lot of traders were extremely bullish on the S&P 500 Index, thinking everything would be fine and dandy, and volatility would stay low. Wrong. Think if you bought the VelocityShares Daily Inverse VIX Short-Term ETN (XIV), believing it would continue to rise since the market was at highs. Well, if you got in and your timing was slightly off…you would’ve nearly lost your entire investment. You would need to understand the ins-and-outs of XIV if you actually wanted to trade this at the time, but this trade is over because XIV has been forced to liquidate.
Even with the recent market dip, I still see market participants piling into one-sided trades, with little concern that they could be wrong.
We see this all the time.
Take Amazon.com (AMZN) for example. When is the last time you heard a bear case on this stock?
Ever hear of a talking head who doesn’t “absolutely love” the stock? Ever hear a fund manager say “we’re not involved with AMZN right now, it is too pricey”?
Chances are you haven’t heard anyone in the media say they don’t love AMZN.
This is when you have the signals of a crowded trade. When you see everyone talking about the trade and a bulk of market participants on the side, be very careful. It means everyone in the world already owns it, and at the first glimpse of trouble they will sell… but who will be there to buy?
How to spot crowded trades
Here is the type of chart I look for when I’m trying to figure out if a trade is crowded.
This shows what a “crowded trade” looks like. You could clearly see hedge funds are all piled into gold right at that point. That might be all good and dandy while gold prices are surging, but you better believe I will be there to short it when it starts to crack. There are just too many people who will be looking for an exit.
Now, see how gold prices were affected…
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Final thoughts: You don’t want to get caught in a crowded trade because it could damage your trading account. Think of Bitcoin and the short volatility trade, you would’ve lost over 50% of your investments if you got into them at the wrong time. Ideally, you don’t want to hop into a trade where everyone is leaning towards one side, and no one really on the opposite side. If everyone is long an asset and it starts to fall, chances are market participants would start selling it, which could potentially cause a panic selloff.
Even in this current market environment, there were crowded trades after the market volatility in October and November. The market found some support and has been getting some nice moves higher.
Jeff Bishop is lead trader at WeeklyMoneyMultiplier.com and widely recognized as the Mensa Trader. He runs short-term trading strategies, using stocks, options and leveraged ETFs.