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How to distinguish between a real and bubble market: Does it matter?

Wed, Apr 6, 12:21 PM ET, by

Bubbles have been with us since the invention of the stock market and price quotes, if not earlier. Their exploitation for profit, and the aftermath of their destructive unwinding is also a common feature of market action in our time. Today, we would like to share briefly our point of view with respect to the role of bubbles in the trader`s list of trading opportunities.

The differences between bubbles and long lasting trends are numerous. Parabolic growth, unquestioning optimism about a trade, popularity outside of the trader community, and invention of new theories and paradigms to account for the irrationalities are some examples of the phenomena that accompany the birth and development of bubbles. But it is also possible to think of them as a degenerate phase of the trend reaching the last stages of its formation before its termination. This is because of the fact that bubbles always end in collapses (that is, they do not plateau, while a genuine trend can), and a trend that transforms into a bubble will almost always be reaching the terminal phase of its existence along with the bubble that it has generated. A bubble is the overheating phase of a trend, where the seemingly linear forces that drive it during its natural development break down into a chaotic form which renders common methods of analysis useless.

But in spite of these differences, distinguishing between a bubble and a trend is not easy, and furthermore, it doesn`t always create the benefits and trading opportunities that a trader might be expecting. Assuming that we know, for instance, that a particular asset is going through a bubble phase, we must make a precise calculation as to when and how to enter a counter-trend trade in that market. But this is usually best left to professionals and experienced traders, since it involves a great deal of whipsaw and wipeout risk. And assuming that we decide to join the bubble and to trade it in positive alignment with the trend, any advantage created by being aware of the trend`s terminal phase will be realized in the money management aspect, and not necessarily in analysis of the price action. While we may minimize our risk by knowing when to exit the market, the improvement in individual positions is probably minimal, as the contrary scenario would contradict our assessment about the chaotic nature of bubbles.

The distinction between the two, then, lies in one`s choice about whether to trade an asset or not. If the market is in a bubble phase, we must know that the risks that we are running are far greater than what is generally being reported in analyst and press reports, since bubbles are usually accompanied with extreme optimism (or pessimism, in the case of the right side currency in the forex market). If the market is only trending, longer term positions may be held. With respect to profitability, trade timing, and risk, during the lifetime of a trade, we believe that the differences do not mean much for an inexperienced trader. And once a trader has acquired the degree of expertise that allows him to recognize bubbles with some effort, he will already have attained profitability in his regular positions, because otherwise he would not have survived long enough to actually observe the development of bubbles multiple times (we exclude short term price spikes from this definition of the bubble, naturally.).

Our conclusion is that bubbles are too commonplace in the market to allow successful exploitation with short term strategies, and in the long term the tactics that allow their exploitation are nearly identical to the usual trend following strategies.

SDI Glossary: "Bubble" Definition
SDI Glossary: "price" Definition
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