Credit: Shutterstock photoThe following is from Steven Drobny's classic, "The Invisible Hands" (emphasis mine):
Beauty contests, playing the player, second-level thinking and viewing markets as a range ofreasonable outcomes are points we write about over and over because the overarching concept is so important, yet so misunderstood.
Let me give you an example.
Your average retail trader (and even most "professionals") read in the paper, magazines and blogs that Europe is on the brink of collapse. Deutsche Bank ( DB ) is teetering on insolvency, populism is rising, the U.K. is leaving- it is all going to hell in a handbasket.
They think to themselves, " Man, Europe is in trouble. I need to short some European banks and sell the euro."
But those playing the game at the second level and above read the same articles and come away with a completely different train of thought:
" Bearish sentiment on Europe is really reaching a zenith, every market pundit and blogger is railing about how bad Europe is. Bearish positioning is extremely one-sided as there is definite market consensus, which means this narrative is likely baked into the price as everybody who is going to sell has already sold. If the public narrative is this bearish, then the central bankers will be too, so they will err on the dovish side for the foreseeable future. That means the entire market is standing on the wrong side of the boat. I need to buy Deutsche call options and go long the euro ."
The first-level thinkers are part of the herd and the second-level thinkers are the wranglers anticipating where the dumb herd will swing to next.
First-level traders believe trading is about correctly predicting the future. They are wrong.
Successful trading is about understanding prevailing market expectations.
Understand the narrative and you can understand the key drivers. Understand the key drivers and you can identify the fulcrum point of the narrative (the data point that if changed, will force a new narrative to be adopted).
Then you take this understanding and closely watch how reality unfolds in comparison to expectations, all while keeping an eye on divergences (mispricings) that create asymmetric trade opportunities.
George Soros ( Trades , Portfolio ) commented on the topic (emphasis mine):
Understand the things you read in the paper, see on Twitter or hear on TV are all popular knowledge -- in game theory this is knowns as common or mutual knowledge. The more widely known the information, the more likely it has already been discounted by the market.
Markets lead the news, not the other way around.
Truly understanding this and applying it is how you become aneffective contrarian . And operating as an effective contrarian is the only way you can win in the game of speculation.
(If you want to learn how to become an effective contrarian, then check out our Trading Instructional Guide . )
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This article first appeared on GuruFocus .
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
