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CATEGORY Trading

Update: How to Exploit Herd Mentality with 80% Accuracy



April 16, 2018

There’s no such thing as the Holy Grail of investing.

If any one ever tells you they’ve found it, they’re full of it. Plus, if they were so good at picking stocks and options with their “Holy Grail,” they wouldn’t share it.

Be aware of that.

But also be aware that one of the best ways to make money on the Street is to simply exploit the naivety of herd mentality.

As we explained on March 18, 2018:

When you pull a rubber band too far, what happens?

Eventually, it snaps back. Stocks do the same.

At times, extreme bouts of fear can send a stock tumbling to excessive unsustainable lows. Other times, extreme bouts of greed can send a stock up too much, too soon. And if we can spot those very extremes, therein lies opportunity.

Once these opportunities appear, 80% success isn’t out of the question.

To find such hot opportunities, we only need two indicators, which have a history of 80% success when used together.

The first is Williams’ %R (W%R).

What’s interesting about W%R is that it historically turns higher or lower before said stock turns higher or lower. In short, it’s the ultimate momentum indicator that signals oversold and overbought conditions. As it nears or penetrates its 20-line, the stock in question is considered overbought. As it nears or penetrates its 80-line, the stock in question is considered oversold.

Then again, we can’t just buy a stock based on a single indicator.

So, we begin to confirm with Bollinger Bands (2,20).

With Bollinger Bands (plotted at standard deviation levels above and below moving averages), stock prices tend to stay within the upper and lower bands. So when prices move to or above the upper Bollinger Band, it’s considered overbought. When prices move to or below the lower Bollinger Band, it’s considered oversold.

Let’s revisit our AT&T example.

Here was the before chart.

Typically, notice what happens when Williams’ %R dips to or below its 80-line, as the stock challenges the lower Bollinger Band. Shortly after, we see a bounce. Now, notice what happens when Williams’ %R runs to or above its 20-line, as the stock challenges its upper Band. Shortly after, the stock pivots and turns lower.

Then again, it never hurts to confirm even more with other indicators, such as relative strength (RSI), MACD and even Money Flow (MFI).

Look at what happened shortly after our mention of what could happen on March 17.

 

The stock pulled back from the upper Band, dropping from $37 to $34 where a put option would have worked out perfectly. Then, once the stock hit the lower Band with oversold reads on RSI and W%R, it bounced again.

We may not have the Holy Grail here, but we have something that works well.

All we’re doing is exploiting a very naïve herd.


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