Lesson #10: How To Distinguish Bubbles (And How To Trade Them)

This is my second post this week (for non-subscribers) and that’s because the recent moves around GameStop have had fairly significant implications for the broader market. Just a few days ago I wrote about How Reddit is Affecting Bitcoin and The S&P (And What To Do About It).

Given the numerous bubbles in the market as a result of that Reddit strategy, I thought it worth our while to go over the different kinds of bubbles there are out there, because they act differently. This brings us to

Lesson #10: How to Distinguish Bubbles (And How to Trade Them)

I’ve also decided to add a new section for the paying subscribers that will give you a list of the Reddit-type bubbles, which are properly feed-back loop bubbles, that are presently still deep value buys (just as $GME was at the beginning).

We’ll get there. Right now, let’s start with what all these bubbles have in common.

What Bubbles Have In Common

All bubbles do have common properties. The key points, for a trader, really boil down to just two items. The first is that they have non-linear price action. This goes back to lesson #1. Here’s an image of the YINN (a 3x levered fund on Chinese stocks).

The second point that makes something a bubble is the way the “asset’s” price does not represent anything like their presently expected value. Instead, it is driven by an emotion of some sort. Greed is not strong enough to do this. 

Rather, I more often look for a transition from despair to elation. Here’s an image of Transocean ($RIG) when it looked like it wasn’t going to go out of business. Oil is in blue while $RIG is in black.

You’ll notice the huge spike in the beginning and the long term upward trend later. You tend to get this emotional surge when a previous bubble popped and it is now coming back. That’s why I outlined what to look for with just this situation in Lesson #8.

Another key emotion is “wow.” Not in the cliched sense, but in the sense of “I honestly didn’t even know that was possible.” I think that’s what happened to the world when it discovered Bitcoin in 2017. Here’s an image of Google searches for Bitcoin for comparison.

Beyond these two points, bubbles have different mechanics for their rise and fall, and these that determine how they should be traded. So let’s jump into the specifics.

Bubble 1: The Pump and Dump

This is the classic “bubble” made infamous in the penny stock world and depicted in the film The Wolf of Wall Street. Just this last week we saw a classic example of this with DodgeCoin.

I actually wrote a post on Quora that this would not go much above 500% because I knew this was a classic pump, and I was right. Here’s the two-week chart on DogeCoin.

The essence of a classic pump and dump is that the “asset” has no intrinsic value whatsoever. DogeCoin was made as a joke–it was supposed to be cryptocurrency satire–and is just barely a functional coin. It doesn’t have intrinsic value and never claimed to have any.

Incidentally, these schemes are illegal to start. But there’s nothing illegal about following them–which is why it’s so hard to crack down on them.

The mechanism for a pump is usually a combination of email and social media campaigns. They sell the fantasy of “being set” (not just greed) with this one big buy. There is nothing more here than the emotional hyping, so as soon as the campaigns stop, the interest in the “asset” stops, and the price crashes back down.

You will have no reason to think that the “asset” just pumped will bubble again because there is nothing intrinsically valuable here. These never trade on the despair to elation emotional run, as a result, because they tend just to pump once.

How To Trade This

Tim Sykes, another philosopher, pioneered the two strategies for making money on pump and dumps.

The first, which is much less successful, is the breakout. Basically, as the pump is going the price will retreat along the way. When the price hits a new high, you can buy the asset briefly (for 5 – 10 minutes) and resell it for a higher price to cash in on the elation that the new high just sparked.

The second, which is by far the more successful strategy, is to short the bubbles. These pumps always crash and you can count on that. They also crash a lot (often 93%-99%), so you can make a ton of money on these crashes.

To do this, however, you’ll need to have a broker that will allow you to do this (InteractiveBrokers is the best for getting you the shares to short, but you need quite a bit of startup capital to use their services $25,000 minimum).

You’ll also want to get in near the top of the pump, since you’ll be losing money while the bubble is going up. And since you’ll probably not guess the top perfectly, you’ll have to make several sells (you are shorting, so you sell first, then buy) to get a closer average entry point. That requires a lot of capital too.

Above all, you need an epistemic asymmetry to make this work. This is where you have a non-symmetrical knowledge (epistemic) advantage over other people in the trade. You need to get to the point where you not only know this is a fake pump, but when the pumpers are going to stop pumping so that it’ll all crash back down.

To do this himself, Tim Sykes built an extensive network where he signed up to hundreds of different spam emails so that he could figure out whether or not the campaign was ending. He also has assistants who help monitor when a stock is falling out of favor real-time to find the top.

If you sign up for his $120 / month classes, he’ll tell you what he’s looking at before opening at 9:30 am, but he won’t tell you when he’s going to trade what, and you won’t have access to his data. As a result, it’s nearly impossible to follow his strategy by following him. 

That doesn’t mean you can’t do this, just that you will need to build your own epistemic asymmetry if you want to try this out.

But why go through all that trouble when you can make just as much money, or more, trading “traditional” bubbles?Subscribe

Bubble 2: The “Traditional” Bubble

Prime examples here are Bitcoin and Tesla. You can figure out an intrinsic value for Bitcoin doing some fancy work adapting Metcalfe’s Law to its network size. For Tesla, you could do a standard discounted cash flow analysis. There is always a reasonable basis for valuing these items and reasonable prospects for growth.

The problem is that these bubbles get ahead of themselves through “wow” emotions and “lambo” fantasies. Tesla, for example, sits at a Price to Earnings ratio at more than 1000. That means that based on the last 12 months of earnings, Tesla would take more than 1000 years to pay you back your investment.

Here’s an image of Tesla and how you would have done if you had gotten in following the momentum methods outlined in Lesson #2.

I’m not saying that Tesla isn’t a good company, but that its current price has gotten ahead of what the company can reasonably deliver. The same thing happened to Bitcoin in 2017.

You have to trade these bubbles. Even if Bitcoin is a great idea, HODLing doesn’t make sense because the technology just isn’t there yet. If you bought Cisco at its height in 1999, you would have been right about the company, but it’s still down 40% since that time.

You cannot invest in bubbles. You must trade them.

How To Trade This

Now you could trade breakouts on these bubbles, just like with pump and dump schemes. But you are going to miss most of your earnings.

The strategy I use, and that is the whole point of this newsletter, is to do the following:

1. Use a momentum strategy
2. Be aware of the basic economic cycle (which will kill a bubble if it turns red)
3. Be aware of the industry cycle
4. Pick a coin or stock that lags the industry indicator (Bitcoin’s price momentum is the industry indicator for cryptocurrencies)

I like Ethereum not only because it’s a better idea than Bitcoin, but because it lags Bitcoin. I can use Bitcoin’s price movement as a lead indicator, buy Ethereum, and get more money since Ethereum is more volatile than Bitcoin.

The same holds for smaller alt-coins like $UNI and $AAVE.

With stocks, I love the oil industry because the price of oil is my lead indicator, and then I buy companies that will survive through the turnaround process like $SLB, or deep bounces like $RIG.

I explain lead indicators and how to use them more thoroughly here. And I explain how to build a momentum strategy here.

Finally, I explain how I use the basic economic cycle and why it really matters here.

This is the only strategy you need to make incredible wealth, but a new bubble type has emerged and it’s worth looking at now.

Bubble 3: The Feedback Loop

GameStop ($GME) has been everywhere over the past week and serves as the primary example. It started out as a deep value buy–ranking as one of the cheapest stocks relative to its earnings in the entire market. But Reddit got hold of it and the price exploded from $4 a share to over $400.

As a note, remember when you typical GameStop store looked like this? Well, actually they still do.

I explained the full mechanics of this kind of feedback loop bubble just this week. In a nutshell, here is how it works:

1. Find a company with a high short interest (higher than 50 % of total shares available for trade)
2. Pump buying call options on the stock via social media (Reddit)
3. Those calls force market makers (the people who actually transact the buying and selling) to buy the corresponding real shares to remain net neutral in all the positions they are facilitating
4. That real buying forces the price of the stock up (= gamma squeeze)
5. Then the hedge funds shorting the company have to exit their positions to prevent more losses buy buying yet more stock (= short squeeze)

So there are two squeezes going on here, not just one, and that’s why this is an exceptionally powerful strategy.

Note also that the call option buying does two things:

1. It allows the people to participate in this practice to make enormous returns, since if things go well, those calls will return 5x-20x the of the stock’s price. So if $GME goes up 200% and you bought way out of the money (risky) call options on it, then your value might go up 200% x 20 = 4000%. Of course, if the price doesn’t go up enough, you lose everything even though you were right about the direction of the stock price.
2. It allows small investors to simulate buying more stock. One call option represents 100 shares of the underlying stock. So it’s possible to buy $1500 worth of calls and force market makers to buy $200,000 worth of stock (for example). That is how the small retail traders are able to force the hands of hedge funds.

These bubbles last longer and go higher than pumps and dumps because they use market mechanics to push the value of the stock price higher. They don’t just rely on emotion. As a result, they “pop” when the price stagnates for too long (no more “wow” emotional effect) or when enough people decide to take their earnings.

How to Trade This

Unlike traditional pumps and dumps, these feed-back-loop bubbles are too risky to try and short. They go up much higher and for much longer. If hedge funds don’t have the capital to survive these, you won’t either.

Instead, a smarter way to trade these is to ignore them if they’ve already taken off. Wait for a “new” pump, and make sure that the short interest is high enough (more than 50%).

Strategy 1: The “safe” way is to buy covered calls. This is not a traditional use for this strategy, but it will give you a lot of upside exposure and protect you from some losses. What you do is buy 100 shares of the underlying stock, and then sell 1 call option at some significant price out of the money–say 80%. You will get paid for the call option, and when the stock goes up 80% you get “called away,” meaning that you get to keep the 80% earning + the price of the call option, but you no longer own the stock.

Strategy 2: Just buy the stock. You will have all the exposure to the downside, but it could go up a lot more–you won’t be capped at 80% earning for example. This would be a remarkably safe method if the stock you were buying was actually a value stock–the kind Warren Buffett would like. In that case, you’d be buying a good stock with the potential for a $GME-style boost.

Strategy 3: I won’t explain this as it is exceptionally complicated and you really need to understand options. For those that know enough, just capture the rise in implied volatility.

Honestly, the “safe” variant of strategy 2, where you buy a Warren Buffett value stock that has a high short interest, is likely the best. In fact, $GME started there.

I have one of these stocks in my weekly newsletter for subscribers and I’ll highlight it for them.

Concluding Thoughts

Those are the three types of bubbles. They all have steep non-linear returns and they all have an emotional push that starts them. But you need to be able to distinguish among them so that you know how to trade them.

To summarize:

1. With a pump-and-dump, you need an epistemic asymmetry to know when to short it to make money off the dump.
2. With a “traditional” bubble, you need to have a momentum strategy, informed by the macroeconomic cycle, to know when to buy and sell.
3. With a feed-back loop bubble, you need to be there for the relative beginning and you should probably sell out after a 400% return on the bubble’s start price.

I just stay out of the pumps. To win at that game you need the epistemic asymmetry with regard to the pumpers’ intentions and I can make plenty of money in a different way.

This newsletter is devoted to giving you the skills you’ll need for the second of these. You can make fantastic returns this way, even more than the other pumps. My $UNI buy is up more than 400% in a little more than a month.

The one problem you’ll have with the traditional bubble is knowing whether the macroeconomic cycle is at least ok. You can figure that out on your own, but my subscription will give you that readout along with the industry health of each sector (and all my own bubble positions too).

Finally, I’m going to add Buffett-style value stocks that could make $GME returns through a feed-back loop in my subscription service for you all. There aren’t too many of these, but some do come along occasionally. And you only need one for a fantastic trading year.

Notes & Disclosures

General financial disclaimer: I am not providing advice on financial investments and I am not a financial advisor. I am only explaining how I think about this process. Please do your own due diligence before investing in anything.

Links may have referral ids: If they do, and you click on them, and you decide to buy something, the newsletter will receive a small commission that will not affect the cost to you.

Specific disclaimer: At the time of writing, I own a variety of cryptocurrencies, including Bitcoin and Ethereum. I might also own some of the stocks discussed in these essays. In general, I trade these, so by the time you read this, I may not still own them