Building Market Assumptions: How to Generate Trading & Investing Ideas

A market assumption is a hypothesis about how a particular market or asset will behave, based on available information, analysis, and the trader’s outlook. For instance, a trader who believes that rising interest rates will strengthen the U.S. dollar might build a market assumption around this belief, leading them to take a long position in the dollar. The rationale behind this assumption is that higher interest rates tend to attract foreign investment, which increases demand for the local currency and, in turn, drives up its value.

Building a market assumption involves analyzing various factors such as historical price data, financial data (e.g., earnings reports), and/or economic indicators. These assumptions may be formed or refined using different approaches, such as technical or fundamental analysis, or they may even stem from a sudden key development in the markets or the global economy. For example, a major geopolitical event might create new opportunities, prompting traders to adjust their assumptions and strategies.

Take, for example, the war between Russia and Ukraine, which escalated in 2022. Many traders speculated that such geopolitical unrest could push oil prices higher due to supply disruptions. As this scenario unfolded, industrious market participants who had built this assumption early on might have initiated long oil positions, successfully capitalizing on the rising prices triggered by the conflict.

Building a market assumption involves analyzing various factors, including historical price data, financial data (such as earnings reports), and macroeconomic indicators. These assumptions may be developed or refined using broad analytical approaches, such as technical analysis (examining chart patterns and price movements) or fundamental analysis (evaluating the intrinsic value of an asset based on financial and economic data). Additionally, a market assumption can sometimes emerge from a sudden key development in the markets or broader global economy, such as a geopolitical event or policy change.

Creating effective market assumptions is a crucial step in developing actionable trading and investing ideas. It helps traders identify opportunities, determine optimal entry and exit points, and manage risk more efficiently. Furthermore, solid market assumptions play an essential role in managing portfolio exposure, ensuring that each position aligns with the trader’s financial goals and risk tolerance.

The process of building a market assumption varies widely depending on one’s strategic approach, market outlook, and risk profile. Different traders may interpret the same event in different ways, leading to varied assumptions and strategies. For example, while one trader may view rising interest rates as a signal to go long on the U.S. dollar, another might focus on its potential impact on equities or commodities.

Generally, market participants act on assumptions in which they have the most confidence. The actionable idea may take various forms, such as buying or selling a stock, deploying an options strategy, or trading in futures markets. In some cases, investors and traders may choose to wait for additional information before acting, or they might even abandon a market assumption altogether if conditions change or further analysis necessitates a shift in thinking. 

Developing actionable investing and trading ideas from market assumptions requires a thoughtful approach. It involves turning a well-researched assumption into a specific trading strategy, which is also cognizant of potential risks, and the overall impact of that approach on the broader portfolio.

When developing investing and trading ideas using market assumptions, it’s important to first acknowledge that different people will arrive at different market assumptions, depending on their experience, knowledge, strategic approach, outlook, and risk profile. A more experienced trader might have a nuanced view of a particular sector, while a beginner may rely heavily on technical indicators. 

Once a market assumption is identified, the next step is to determine how best to translate that assumption into an actionable form in the markets. Listed below are some of the steps/considerations that investors and traders can utilize when developing actionable investing and trading ideas from their market assumptions:

Clarify the Market Assumption

• Objective: Clearly articulate the assumption, whether it is based on technical analysis, fundamental analysis, or macroeconomic events.

• Example: If you assume that interest rates will rise, resulting in a stronger U.S. dollar, you need to understand the potential impacts on currency markets and related assets.

Choose an Appropriate Asset or Market

• Objective: Determine which asset or market best aligns with the assumption. This could be stocks, options, futures, or ETFs depending on the assumption and the type of exposure you want.

• Example: If you believe a tech company will outperform, you might decide between buying the company’s stock, trading its options, or instead trading the stock or options of a tech-focused ETF. 

Select a Strategy

• Objective: Identify the most suitable trading or investing strategy based on the assumption and the asset class chosen.

• Example: If your assumption is that gold prices will rise, you could consider trading gold futures for direct exposure or using an ETF like VanEck Vectors Gold Miners ETF (GDX). Static delta trades or dynamic delta options trades depend on the nature of your assessment and risk tolerance.

Assess Risk and Manage Exposure

• Objective: Measure the risk involved in the strategy, considering factors like volatility, correlation to other portfolio assets, and time horizon. Tools like stop-loss orders and position sizing may be used to help manage risk.

• Example: If you have a long position in an oil company but are concerned about increased volatility in the energy markets, you could set a stop-loss order at a specific price level to limit potential losses. This ensures that if the price drops below your predetermined threshold, the position (or part of the position) will be automatically closed, helping you manage risk without needing to constantly monitor the market.

Establish Time Horizon and Exit Strategy

• Objective: Align the time horizon of the assumption with the chosen strategy and product. A market assumption based on a short-term event like earnings may lead to a different approach than one based on longer-term trends, such as interest rate policy.

• Example: If you’re looking to play an earnings event using options, it’s generally preferred (depending on the strategy) that the options associated expiration period captures the event.

Evaluate Correlations and Diversification

• Objective: Consider how this potential position fits within your broader portfolio. Ensure that adding the position does not overly concentrate risk, or violate your diversification goals.

• Example: If your portfolio is already heavily weighted in tech stocks, adding another tech-related position could increase your exposure to the same risk, thereby amplifying the volatility of returns across your portfolio.

Monitor and Adjust the Position

• Objective: Regularly review both the market assumption and the performance of the position. Be prepared to adjust or close the position if new data or market conditions invalidate the original assumption.

• Example: If you were long on a stock due to its strong earnings potential, you might reconsider your assumption if the company unexpectedly posts a poor earnings report, as this new development contradicts your original thesis.

Review and Refine 

• Objective: After the position is closed, review the outcome relative to the original assumption. Did the strategy play out as expected? What adjustments could have been made? This reflection will help in refining future market assumptions and strategies.

• Example: If your assumption about oil prices rising was correct but the gains were lower than expected, reviewing your entry and exit points or strategy (e.g., options instead of futures) could lead to better results in the future.

Listed below are some popular strategies that can be used to deploy market assumptions. 

Keep in mind that this is just a small subset of the available products and strategies; investors and traders can explore a wide spectrum of possibilities when determining the most effective way to express their market assumptions. The optimal product/strategy will depend on a variety of factors and how the product/strategy ultimately aligns with the original market assumption. 

• Long Stock: Buying shares of a company with the expectation that the stock price will rise.

• Short Stock: Selling borrowed shares in anticipation of a price decline, with the intention of buying them back at a lower price.

• Long ETF: Buying an exchange-traded fund (ETF) to gain exposure to a specific sector, index, or asset class, with the expectation that it will rise.

• Short ETF: Selling an ETF or using inverse ETFs to profit from a decline in a specific sector, index, or asset class.

• Long Futures: Entering into a futures contract to buy an asset at a predetermined price, typically used when expecting the price of the asset to rise.

• Short Futures: Entering a futures contract to sell an asset at a set price, typically when anticipating the asset’s price will fall.

• Long Call: Purchasing a call option to benefit from a potential price increase in the underlying asset.

• Long Put: Buying a put option to profit from a potential price decline in the underlying asset.

• Short Call: Selling a call option to collect a premium, typically when expecting little or no price movement, or a decrease in the asset's price.

• Short Put: Selling a put option to collect a premium, often used when expecting the asset’s price to remain stable or increase.

• Covered Call: Holding a long stock position while simultaneously selling a call option to generate additional income. Can also help hedge downside risk. 

• Long Straddle: Buying both a call and a put option with the same strike price and expiration date, betting on significant price movement in either direction.

• Short Straddle: Selling both a call and a put option with the same strike price and expiration date, aiming to profit from low volatility and minimal price movement.

• Protective Put: Holding a long stock position while purchasing a put option to limit potential downside risk.

• Collar: A strategy where an investor holds a stock, buys a protective put, and sells a call, limiting downside risk, but also limiting potential upside gains. 

• Pairs Trading: Going long on one asset while shorting another related asset, often used when assuming a spread or valuation discrepancy will revert to the mean.

Market assumptions, while a critical component of trading and investing, are inherently limited by several factors, including incomplete information, market unpredictability, and cognitive biases. 

One of the biggest challenges is that assumptions are often formed with access to only partial data. Important variables, such as undisclosed financial information or sudden geopolitical shifts, may not be available, potentially skewing the assumption. Additionally, markets are highly unpredictable, with unforeseen events—like economic disruptions or natural disasters—able to derail even the most well-researched assumptions. 

To help mitigate these limitations, it can be prudent to incorporate a combination of strategic analyses when forming and validating market assumptions. For example, by using both technical analysis (which focuses on historical price patterns) and fundamental analysis (which evaluates the intrinsic value of assets), when assessing a potential long stock position. Using a multi-faceted approach can help cross-validate assumptions, and potentially enhance decision-making, reducing the risk of acting on incomplete or overly biased information.