You are walking in the garden, and you see a trail of ants walking and heading back to their nest underground. The interesting bit is they are blind, so how do they manage to follow each other and communicate so well? They actually secrete chemicals known as pheromones, which help them communicate and mark trails that help locate food and return home. Now imagine what would happen if a group of ants took the wrong route and disrupted the straight line of the trail? Since no ant knows how to reach home safely, they follow one rule: follow the pheromones secreted by the ant in front. If enough ants follow this, they eventually form a circular mill. They keep moving in circles until they die of exhaustion or starvation. It's pretty ironic; the only thing they know that brings them home safe is what causes them to lose their lives. Here is an image for reference:
What metaphor am I drawing that makes them similar to momentum traders?
Momentum trading lies in the thesis that a stock going up will keep going up or vice versa( Very similar to Newton's law: an object in motion will stay in motion). The thesis sounds appealing, and many traders have definitely made money out of it. However, the strategy becomes a curse when the rally is at its point of exhaustion. This is where the metaphor comes into play. Many momentum traders(ants) blindly follow the price(other ants) and hope that the price keeps rising until it doesn't, which eventually kills the capital. This observation is the greater fool's theory. Both of them follow the trend and trust the strategy unquestioningly as long as the scent of opportunity is strong, even though it's temporary.
I am not saying momentum trading is wrong; I started using technical analysis and trend trading in the stock market before I learned to invest, so I, too, believe in its usage. The purpose of this metaphor is to talk about the limitations and dangers of trend trading that is rarely spoken of nowadays( probably to entice retail investors into buying courses :(.... ) So, I decided to talk about ways that will help avoid a free fall in capital when it comes to trend trading:
Fundamentals are a thing: Stocks do not move because of a breakout; they only move when fundamental triggers come into play, which is eventually reflected on charts. Similarly, we can never know when a trend will reverse or die out, but we can certainly get a fair estimate by knowing the rough valuations of the business. Even Mark Minervini, a great trader, heavily relied on fundamentals, so why shouldn't we? It isn't necessary, but it's certainly beneficial if you pair technicals and fundamentals.
Herd mentality bias: This bias means that people follow some beliefs without independent analysis with complete trust in others; basically, it is a behavioural bias. Without correctly understanding the 'why' of the trend and investing just because the rest are, it is a big mistake and can lead to severe losses. However, I have realized that borrowed conviction is a more significant issue in following the herd. WE CAN'T RELY ON BORROWED CONVICTION. Sooner or later, we will crumble to the price fluctuation because we don't have a robust enough thought process to back it.
Tailwinds: Trend trading is helpful when there are tailwinds in the industry. Why have railway stocks, defence, EMC, cables, hotels and real estate followed their trends very well while stocks such as Deepak Nitrite and Balaji Amines have fake-outs? It all comes down to understanding the sectoral cycles at play. By picking out sectors that could perform well (I will write another article on identifying this), we significantly improve the odds of picking the right stocks and increase our RR.
The ants are creatures that can't help but end up in a death spiral. However, we are not. We can think and train our minds in a way that yields the best results. Hence, we should learn and think. I hope this blog served its purpose by being entertaining and informative.
Key takeaways
Momentum traders are like army ants when they follow the herd mindlessly. We need to develop robust thinking that prevents it.
Despite being a trader, study fundamentals and connect them to your strategy
Do not fall prey to herd mentality, and do your own analysis. Borrowed conviction won't last long.
Shortlist sectors that could do well and track the leaders of those sectors like a hawk.
Dedicate time every day to learning and analyzing. It's essential to continue improving.
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