How To Trade (Or Not) When Positions Are Looking Crowded

How To Trade (Or Not) When Positions Are Looking Crowded
Russell Burns

over 1 year ago5 mins

  • Crowded trades do have certain defining characteristics: extremely strong investor sentiment, which can be very positive or very negative; and an asset price that’s trended sharply in one direction, leading to a lot of overweight positioning.

  • Crowded trades can happen in stocks, bonds, commodities, currencies, or even alternative asset classes like crypto or real estate. It can strike a single stock, a whole sector, or even a strategy.

  • If you want to invest in crowded trades or position yourself for when the trade reverses, size your position according to your appetite for risk, because, with so many investors betting on the asset, its price can move swiftly.

Crowded trades do have certain defining characteristics: extremely strong investor sentiment, which can be very positive or very negative; and an asset price that’s trended sharply in one direction, leading to a lot of overweight positioning.

Crowded trades can happen in stocks, bonds, commodities, currencies, or even alternative asset classes like crypto or real estate. It can strike a single stock, a whole sector, or even a strategy.

If you want to invest in crowded trades or position yourself for when the trade reverses, size your position according to your appetite for risk, because, with so many investors betting on the asset, its price can move swiftly.

Mentioned in story

Stocks have continued to rally, even though the US economic outlook appears increasingly wobbly. Part of the reason isn’t optimism: it’s crowded positioning. And it’s something you’ll want to be aware of. When trades get crowded, they can present big opportunities and big risks. So, let’s take a look at how you can spot a crowded trade, and how you can avoid them, or benefit from them…

What is crowded positioning?

Crowded positioning generally happens when a trade becomes wildly popular, and gets adopted by huge numbers of investors who are all betting the same way. They pile into crowded long positions, over-owning those assets when sentiment is overly positive. Or, it can work in the opposite direction, with investors piling into short positions, and under-owning an asset when sentiment is overly negative. And this can occur in any asset class – in stocks, bonds, commodities, currencies, or even alternative asset classes like crypto or real estate. It can strike a single stock, a whole sector, or even a strategy.

Crowded positioning often leads to overly inflated asset prices – think: bubbles – and bubbles do have a habit of popping. When bullish investor sentiment suddenly shifts to bearish on a crowded trade, for example, and sellers far outnumber buyers, the drop in price can be severe. When a crowded trade sees an unexpected shift like that, one that sideswipes a big group of investors, it’s often referred to as a “pain trade” because those investors face the painful dilemma of whether to hold out hope that the trade will eventually work out or whether to cut their losses. Of course, some investors won’t have a choice at all: those trading on margin, or with borrowed money, will sometimes be forced by their brokers to liquidate their positions.

How can you spot a crowded position?

While they aren’t always easy to spot, crowded trades do have certain defining characteristics. Generally, they have really extremely strong investor sentiment – either in a very positive or very negative way. And often, the asset’s price will have trended in the same direction for a long period of time, leading to a lot of overweight positioning, with so many investors piling into the same asset. But, sometimes, the crowding happens over a very short period of time, moving the stock sharply.

And that’s what we’re seeing this week with Bed Bath and Beyond (BBBY-O). The meme stock home goods seller rocketed 79% higher in intraday trading on Tuesday, as retail investors talked up the stock on the Reddit forum WallStreetBets, encouraged by news that GameStop (GME) chairman and activist investor Ryan Cohen had placed another bet on the retailer. Trading in the stock was halted several times during the day because of all the volatility, and the stock ultimately ended the day up about 30%. The stock has now rallied nearly 400% in two weeks, and there’s a real risk that this is now a crowded long position. But that doesn’t mean the position can’t get more crowded or that the stock can’t continue to rally. In a crowded long position, increasingly sharp outsized moves in both directions are possible.

What are some of the other examples?

Probably the most extreme example of a crowded short turning into a massive pain trade was the January 2021 “short squeeze” of GameStop’s shares. It happened as millions of retail investors pushed the shares of the video game retailer from $20 to $420, driving hedge fund Melvin Capital to lose 53% of the $13 billion assets it was managing in one month.

But position crowding can also happen over a far longer period: for example, the Nasdaq. The index had been rallying for much of the past five years. Then in the first half of this year, the Nasdaq dropped, falling 29.5%, as investors exited those over-owned, crowded positioning in growth and technology stocks. See, the optimism about tech stocks was overdone.

The tech-heavy index has since rallied – it’s up 18% since the end of June – and part of the reason for that is the flip side of this coin: short covering. Back in June, sentiment and positioning were overly negative, with concerns about a possible recession and even-higher interest rates. Overly negative sentiment often leads to crowded short positioning, including by big investors, who need to cover their short positions as the markets rally.

Crowded positioning in single stocks like Bed Bath and GameStop tend to lead to more volatile and outsized moves – they’re smaller, after all – than in large indices like the Nasdaq and the S&P 500. Typically when an asset has been trading in the same direction for a long time, there is an increased risk of positioning being crowded and an increased risk for an unwind of the position.

What are the lessons and opportunities here?

The safest and most risk-averse approach with crowded trades is to try to avoid trading in them altogether. And while it might be tempting to try to time the reversal in a crowded trade, it’s very difficult, so be careful. Unless you’ve got a lot of appetite for price swings and profits and losses in your portfolio, you probably don't want to get involved.

If you want to invest in crowded trades, size your position according to your appetite for risk, because these trades can move swiftly. If you think a crowded trade is going to reverse in direction, you can position yourself against the current trend. But size accordingly, as it may be a painful ride. No trader wins all the time. Learning to deal with the emotional and psychological aspects of trading is an important (and difficult) skill to learn.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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