The two types of trading games you can play (part 1 of 3)

Retail traders often can't understand why they don't get any respect …

That's because most retail traders don't know the game they're actually playing.

So over the next few days I'm going to lay it all out for you.

Here we go:

There are two types of trading games.

Risk premia games and Alpha harvesting games.

It's nearly impossible to be any good without knowing these.

Risk premia games are where you take on risk other people don't want to take on.

You don't really want to risk having your house burn down so you buy insurance.

You aren't really trying to make a profit, just avoid the possibility of having the worst day ever.

So it's reasonable to expect the insurance company to make a profit.

They are taking on a risk that you'd rather not take on…and you're happy to pay them to take it.

It's not a really difficult game for them.

It's not difficult to understand, or model out…but there are going to be some rough days.

They get a big fire that burns down a whole town and they're literally eating a punch to the face.

This is important to understand.

They get the risk premium for taking the pain.

Know this…

No premium, no pain!

Here's one way to think about it.

Let's say your house has a septic tank.

The previous owner of your home swears up and down they had it pumped on a regular basis...

However, one evening you return home only to find the toilet in the bathroom that is connected to your bedroom backing up all over the carpet.

Now, do you grab the plunger and try to fix the problem yourself or are you happy to pay a company to come out and take care of the problem for you?

The company of course, and you'd probably be happy to give them a tip as well...

Plumbing is synonymous to risk premia games.

Taking on risk others don't want, like a plumber.

You see this everywhere in life.

Value investing is buying companies below their fair value.

While everyone else is goggle-eyed at high profile growth stocks like Tesla and Amazon…it stands to reason that people will systematically overpay for the high profile growth stocks, and the boring stocks will trade cheaper than they should.

Makes sense, right?

It's risk, and other people don't want the boring stocks because they're not glamorous.

After all, it doesn't exactly feel like an accomplishment to be long General Electric and McDonalds while Tesla goes to the moon.

So there's a long term Premium for those with the guts to stick it out.

Of course growth stocks have beaten value stocks for the last 20 years…but in the next 20 years we could see a comeback for the ages.

There's a few of these different risk premia games we can play.

Carry trades are one of the strongest edges in all of finance.

Here's a backtest of carry on the USD major FX pairs...

And here's how it works in crypto...

Looks incredible, right?

But not so fast.

Carry tends to perform poorly at the exact time you'd prefer it not to perform poorly.

Everybody hurts some…times…but it's the absolute worst to be hurt when it hurts to be hurt.

When you could really use your cash to go buy some cheap coins or stocks.

Remember, no premium, no pain!

Carry is awesome and challenging at the same time.

There's one more type of risk premia game we can play.

And it's the strongest one of all...

Trend, sometimes called Momentum.

It explains 61% of the total price movement of stocks over the last 100 years.

In fact, if you throw Trend, Value, Quality and Defense into all the stocks that have ever been traded over the last 100 years...

They mathematically explain 95% of all stock returns.

The great mystery of why stocks go up and down (which we all try to solve by drawing lines on charts) is mostly solved now.

So riddle me this;

If you can explain 95% of stock returns with these 4 "factors" (and by the way, this isn't some theory I made up, this is literally something with a Nobel Prize in finance backing it up)...

What is left for technical analysis to explain?

And why does technical analysis work?

Well...technical analysis works to the extent that it recognizes those factors.

When you are buying a pullback in an uptrend you are buying momentum.

When you are buying a breakout you are buying momentum.

Most of the technical analysis that's not B.S. is based on "the trend is your friend."

But we aren't in the pre-computer age anymore so you can actually put a number to it.

But not so fast...

No premium, no pain!

So what are the cons when it comes to the trend?

Well, it has a very Low win rate.

See, you're holding out for the biggest 10 bagger and 100 bagger wins…so you might just be waiting a while.

You can kind of mitigate this by taking many swings at bat, but still...the trend poses a challenge.

When you trade trend manually, you'll have stretches of 14 or more losing trades in a row.

Retail traders lose because they believe, "this has stopped working" and switch it up, just before things become good again.

Unfortunately, unless you're quite experienced, you aren't going to be able to do this without a computer program.

Of course there are algorithms to do it all without you having to know or do a thing…because Trend and Carry work powerfully together…

Like Batman and Robin…

Trend and Carry are best friends forever

So, let's summarize;

Risk premia games are taking on risk other people don't want.

The strongest risk premia with the most evidence are Trend, Value, and Carry.

Crypto valuations can be suspect, so we can't go there…but it's no accident there are some very reliable crypto-trading systems built on the two strongest risk premia.

So that when one doesn't perform, the other still does.

Remember, no premium, no pain!

Keep an eye on your inbox tomorrow for the next message in this series where I explain the next type of trading games...

Alpha Games.

Russell DeCorte
Director
Markets Pro