If you’ve been in markets long enough, I’ll bet you have surely encountered a situation where you were absolutely sure that something was going to happen. And as it turned out, you called it and you were right. But somehow, you still ended up losing money on the trade. Does that sound familiar?
Well, I would say it’s one of the biggest traps that a trader can fall into. It is the very fact that even having a convincing market story doesn’t necessarily mean you have a good trade.
Let’s go back to our little apple store example, shall we?
Just imagine that you are selling apples and one day, you hear that bad weather has damaged apple harvests across the country. With that information, you quickly make the connection that supplies are going to fall and apple prices should go up because of that.
Hence, you decide to stock up on apples at $2 each, hoping to sell them for $3 later. That sounds like a decent business opportunity, no?
But then, here’s the catch though. You’re not the only person with this information. Everyone else has heard about the bad weather too and other sellers have already rushed to buy apples, pushing the price from $1 to $2 before you even had a chance to get in on the action.
And by the time you do and when the shortage does hit, apple prices only go up from $2 to $2.05. You were right about the shortage. You were even right that prices did go higher. But after accounting for transport, storage and other expenses, you might have barely made any money on the sale – if at all.
Now, there’s even a worse scenario than that. What if the bad weather did not do as much damage on apple harvests as initially anticipated? Apple prices could fall back quickly to $1.70, , leaving you with a loss despite having a perfectly reasonable argument.
It’s the same thing as trading and in markets too.
Let’s say that you anticipate inflation will rise because oil prices are surging higher to above $100 again. You make the connection that higher oil prices can push up consumer prices more broadly at some point, potentially forcing central banks to keep interest rates higher for longer.
So, you take action in buying the dollar as you expect the Fed to keep tighter monetary policy compared to other central banks, which should give the dollar some support. But then, here’s the catch again. What if everyone else has already made that same trade?
The dollar might have rallied considerably before you even got involved. And when inflation eventually comes in higher, the currency might barely react because markets had already anticipated it. Worse still, you might even be hit with a case of buy the rumour, sell the fact. And that’s a painful lesson to learn as you would have lost money on the trade despite getting the economic story right.
As such, it is always important as a trader to pose the question of what markets have already priced in and how much further could prices realistically move. But perhaps also more importantly, you need to understand and grasp how much you stand to lose if you’re wrong.
Because knowing that apples will become more expensive is one thing, but knowing whether they’re still worth buying at today’s price is another. And in trading, that difference itself can cost you money.
This article was written by Justin Low at investinglive.com.