Energy Trading Plan for February 7-11 and some trading thoughts from the sportsbetting world
Feb 6, 2022 Trading Blog
I’m going to separate this week’s post into two sections. The first section is some thoughts on how I view trading and why I make some of the calls I do based on an analogy to sportsbetting. The second part of the post will be my technical thoughts on the energy sector and this week’s trading plan on the XLE short.
Before I got into trading around 1998, I was seriously into sportsbetting. Surprisingly, trading and sportsbetting are very similar. I had the same problems with my early sportsbetting as I did in my early days of trading. The biggest problem I had in sportsbetting was that I thought the endeavor was about being right. I thought it was about being smart enough to determine which team was going to win the game. Similarly, in trading I always thought it was about being right in predicting which way the market would go. Both of those approaches were absolutely wrong.
When I started betting, my method was to find the biggest mismatch on the board and bet that game. If the greatest pitcher in the world (usually Greg Maddux) was pitching against the worst team in the league, that was my bet. I was great at it, usually hitting that bet around 65-68% of the time. If you know anything about the sportsbetting world, the elite handicappers run around 58-60% correct on their picks. I was going to be rich. But after a few months of getting most of the game picks right, I hadn’t made a penny, in fact, I had less in my bankroll than I started with. How was this possible? How was I this good at picking winners, yet I was losing money?
I wasn’t making money because I had ignored (or simply didn’t know) that the game wasn’t about being right. The game was about risk and what you won when you were right versus what you lost when you were wrong. Simply put, the price of the bet. I was betting the most expensive games on the board, most of which had odds of about -300, which means I was betting $3 to win $1. I had to hit 75% of my bets just to break even. My 65-68% win rate looked like I was very good at what I was doing, but the bottom line math said I was a loser.
So what was the solution to my sportsbetting (and trading) problem? I had to stop worrying about being right. I had to be willing to bet on something that I was fully aware would probably lose more than it won. I had to let go of the ego and be willing to be wrong, A LOT. So, instead of betting on that favorite at -300, I searched for situations where the underdog wasn’t such an underdog. If I could find a situation where the underdog had at least a 30-35% chance of winning, I would make a nice profit at the -300 price. Yes, I was going to lose twice as many bets as I won, and that makes you look kind of stupid, but that was the profitable way to approach sportsbetting (and trading). You can’t be in it to be right, you have to be in it to make money. Set the ego aside and be willing to lose a lot in order to show a profit on the bottom line.
So how does this apply to trading? I see so many traders wanting to be right all the time, some because of pure ego and some because they just haven’t given the underlying math much thought. They jump on uptrends or downtrends very late because that’s what everyone else is betting on. These established trends are much like the -300 favorites in baseball. They do this much for the same reason that I would bet on huge favorites, because they think trading is about being right. But, they never give much thought to how much their bet/trade really costs. They don’t consider how much they win when they are right versus how much they lose when they are wrong. Simply put, they never consider the price of the bet/trade they are making.
The basis of any trade should should never simply be “which way do I predict the market will go?”. Much like the winner of the mismatched baseball game, that simple market direction question is usually very easy to answer correctly. However, you always have to go one step deeper. The basis of any trade should always be “how much will I win if the market goes as predicted and how much will I lose if it doesn’t?”. This line of thinking will often put you adverse to the current trend and the crowd. You have to be willing to be comfortable with that, just as I had to accept being wrong a lot by taking underdogs that would probably lose more times than they won. The only thing that matters is the bottom line profit. Don’t be in the game to be right, be in the game to make money.
So applying those thoughts to the current XLE situation, I see many simply thinking, “the trend in XLE is up, I’m going long!”. They want to be right. But they never stop for a second and think about how far that trend will go up AND if it doesn’t go up then how far will it go down? They are essentially betting the -300 favorite and they win for the most part, but they don’t profit over the long haul years. The smarter bettors/traders analyze the predicted direction of the trend, but they also analyze the potential reward and the potential loss. Many times the result of that analysis is to take the other side of the trade from what the crowd is taking. Simply put, sometimes the correct trade is to take the underdog, which will be wrong many times, because that’s where the superior risk/reward and resulting profits are.
In summary, trading isn’t about being right. Trading isn’t a place to feed your ego about how smart you think you are or how you look to others. Trading is about making profits. Many times, once the math is figured in, the more profitable trade is the one that has a higher chance of losing than it does winning. Many times the more profitable trade is the one that goes against the current trend and crowd. Sometimes you just have to bet against Greg Maddux.
This Week’s Trading Plan
As most of you know, I tried the XLE short at 61 and covered it at 60.70 for basically a breakeven scratch. I had estimated a couple months ago that there would be a peak around 60-62, and I waited patiently on that level, but I was wrong. I don’t think this incorrect trade was because of my view of the sector and its fundamentals. The factor that I didn’t incorporate was one that didn’t really exist at the time I set that 60-62 short area. That factor was the geopolitical situation with Russia. If I had to select one driver of this market right now, this is it. Oil is getting pushed to very overextended levels due to anxiety over a possible conflict. It could keep getting pushed higher the longer this potential conflict exists. Actually, I hope it does get pushed higher based on this because once that situation is resolved, there’s going to be very little to hold this market at these lofty levels. When things fall from very extended levels, the downside momentum can be huge as everyone heads for the door.
Just like other conflicts such as the early 90’s Kuwait situation, there’s always a runup in oil price as the conflict comes to a head. It’s a buy the rumor situation. This time the buy the rumor situation just happens to be occurring in the later stages of an already existing market trend. But as we’ve seen with almost every other conflict, once that first shot is fired and resolution approaches, oil price crashes. This time it could crash from a very high level and produce an overreaction to the downside as everyone heads for the exit at the same time. I’d estimate over half the traders in oil right now are in it because of this geopolitical situation. The remainder are in it for an inflation play. When the geopolitical calms, will those traders stick with their oil bets, especially as rates are expected to rise to levels that will likely also cure the inflation problem?
In addition, can this economy withstand an oil price spike right now? Oil prices have often been a major factor in producing recession conditions. Will the government torpedo oil prices with a quick resolution of this Russia issue? Never waste a good crisis, right? There’s much at stake right now and the government will be forced to be on the opposite side of the oil bulls. Do you really want to fight government forces at these oil price levels?
As I’ve posted a few times recently on Twitter, I’m not saying the sector can’t go higher. But, going back to the baseball analogy above, how much profit is left in the market versus how much downside risk exists if the geopolitical situation resolves? Are traders mostly late to the party at this level? Is establishing a position after such a huge extended run (built atop an existing uptrend) based on geopolitical tensions really such a good play when you consider the downside risk? I don’t think so, which is why I started in short again last week.
My current short position in XLE is 68.67. I’m scaling in slowly on this one and have about 30% of what I want. I’d like to see XLE spike somewhere toward that 73-75 level, which is about another 10% up. There are a few things that I think could get it there. First, I think this government is fairly incompetent when it comes to diplomacy and resolving conflict. There’s the potential for them to really screw this whole Russia thing up badly and that could spike oil prices. Hate to see it, but that’s what I need for a great short play. The second factor is something I’ve been watching for awhile, IWM. I still think it has a chance of spiking upward, which would likely take XLE and KRE up with it. Maybe we even get the perfect storm of all of this happening in sync.
I think the primary question you have to ask on any long play up here (or short play) is how long can oil prices stay this high? How long before it becomes an economic issue? How long before the government gets on the other side of your long play and targets high oil prices? How long before high oil prices cure high oil prices? How long until the geopolitical situation resolves? How long until the next covid scare? So many possibilities that make a long play up here very risky and a short play much more rewarding.
Anyway, that’s just some thoughts on where I’m at right now with energy and the XLE play. I’m still trading other areas of the market, some with success (XME, GDX, KRE and ITB), some with not so much success (microcaps). I hope the sportsbetting analogy was helpful to understand why I so often take trades that appear to be against the crowd. I know many times my trades look like losing propositions, and many times they are, but it’s not the winning percentage that matters, it’s what you make when you win versus what you lose when you are wrong. Good luck this week and definitely protect those profits in this crazy energy market.