Fading usually means picking up a few “dogs.” Image credit: www.tradingacademy.com (CC by 2.0)
In investments, fading refers to a strategy than runs counter to the current prevailing trend or wisdom. As such, it comes with a high amount of risk, and is only appropriate for investors with high risk tolerance. When the majority is selling, the fade investor will be buying; and when everyone else is buying, the fade investor will be selling. This usually means a fade trader will sell when a price is rising and buy when a price is falling.
Fading the market can take on several different forms. One common fade strategy is buying on a dip in price and selling when the stock rallies. This is a volatile strategy designed primarily around short-term gains and betting that the downward trend will not continue. Another strategy is looking for stocks with low price-to-earnings ratios, which could mean that the company is undervalued. In an upward market, a fade trader might prefer value stocks to growth stocks; and then prefer growth stocks to value stocks when the market goes down. A popular fade strategy known as the Dogs of the Dow was established by money manager Michael O’Higgins in a 1991 book. It involves buying equal parts in the 10 highest-yielding stocks in the Dow Jones Industrial Average at the start of the year.
A fade strategy works best when the investor is able to analyze a particular company in-depth. Factors such as solid management teams, groundbreaking products, efficient practices, and good profit margins can make a company a solid investment even when it is unpopular. Since market reversals tend to depend on economic facts rather than investor psychology, a fade trader with a strong stomach and thorough analysis can do very well.
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