The last week was very difficult in the markets. After I wrote my market overview blog post, the S&P, NASDAQ and Russel broke down. What seems like a crash in the daily chart looks like a pause or start of a correction in the weekly and monthly chart. But we never know exactly what comes next.
Normally new traders start trading in bull markets. Bull markets attract people to get involved in the stock market because everything looks easy. The markets only know one way and every pullback get bought. It’s easy to buy a stock and the gains flow into your account …
But if the first correction of the market starts, the most new traders lose all their gains and more. Why? Because they did not learn anything about the markets, position management and risk management. You cannot get enough experience in just one market cycle.
I personally get involved in the markets around the 2008 crash and earlier. After some years I started to get seriously interested in the stock market. I know what it means to get trough difficult periods. But my experience is just a blink in the eyes of market participant with 20, 30 or 40 years experience.
10 rules and experiences for difficult market environments
Here are 10 rules and experiences which I think are important in a volatile and difficult market environment:
- Cash is a position: To stay in cash and on the sidelines is a deliberated position. It’s a tool in the traders toolbox to avoid losses. Of course you cannot make any money, but you will easily outperform the markets.
- Going short is different than going long: Emotions in volatile and difficult markets are different. The fear of losses are different from the greed of gains. The rules to play the short side are different and maybe you need different strategies. Fast snap back rallies will throw you out of your position. In addition the chance-risk-ration of the short side is limited: A stock cannot go down more than 100%.
- Not all stocks are a good short: Shorting stocks can be dangerous. Imagine you short a biotech company and good news appear on the screen. The stock opens with a gap of 85% or 120%. The loss you realize is terrific. The same happens if a company get bought out. Especially if you short a cheap stock and another company pays a high premium. My rule: Avoid cheap stocks and biotechs, trade small short positions.
- Inverse ETFs helps to spread the risk: To decrease the risk of a single stock you can trade ETFs. There are inverse ETFs which follows a basket of stocks or an index with a negativ correlation. That means that if f.e. the S&P 500 falls 1%, the inverse ETF will rise 1%. There are inverse ETFs on the most sectors, forex and commodities. But make sure that the ETF you buy is liquid enough (>25k volume in average per day).
- Look at other markets: If you are an experienced trader and you know your edge, you either stay out of the market or you look at other markets. There are several markets out there: Forex, commodities, bonds. Some of them have a correlation to the stock markets, others are independent.
- Monitor your trading journal: You will not perform superb in any market cycle. The trading journal and your taken trades shows how your strategy performs. If you see that you have a negative outcome of the last 20 trades, scale back. You approach seems not to be working in the current environment. That’s why monitoring your equity curve and trading journal is essential.
- Find a mentor: There are a lot of traders out there which have long experience in the markets. They went trough multiple market cycles and are still here today. Find such a person and apply to a mentoring program. Even if you will not make any profits, you will profit a lot from the thoughts and tactics of the mentor. My two mentors in the past and today were the best investments I took!
- Defend your equity agains draw downs in any dimension: The most important thing is that you defend your equity curve against a big draw down! If you equity goes down 5% or 10% it is possible to get to new highs quickly. But if you have a draw down of 30% or 50%, it is very difficult. You will need a long time to see new highs. That’s why it’s important to have the most possible small draw down. Do anything what’s necessary: Small position sizes, stay out of the market, sell quickly or give up trading until a better environment appears. But never let your capital erode!
- Never buy bottoms: After weeks or months out of the market, it will start to itch in your fingers … You may think that some stocks are oversold or see bottom formations. But I can say from my experience that from one night to the other a gap down of 5% or more is possible. If big funds must liquidate their positions, they sell without any other thoughts. You have to be patient until a lot of stocks build strength, make new highs and the bias in the markets changes. That needs time!
- Do something else: I have some other activities besides trading. I also think that this is very important. If you look at the markets all the time, you will do stupid things. It’s much more effective to make a plan and execute the plan. So go out and find other activities to spend you time … As Jesse Livermore famously said: There are times to be in the markets and there are times to go fishing.
The 11. rule …
There is one hidden rule I want to write about: Psychology. The most new traders fail because they think trading is easy and get punched in the face if the time gets difficult. In that second they learned that the markets are bad and no one can win.
The thing that they don’t grasp is that successful traders started out the same way. The only difference is that they react different to the hurt they got from their first punch.
Unsuccessful traders give up quickly because they are only interested in excitement and the money. Successful traders are interested in the challenge and the game itself. That’s just a different view of the same thing. But the first trader will never get back to the markets like a child bitten by a dog, the second will return because he is interested in animals and learned that they are not always kind and cute.
So ask yourself: What type of trader do you want to be? I can give you a tip: Be the second, buy a lot of self-help and motivation books and bridge the time between the end and start of a bull market.
Here is a small list of recommended trading books about this topic.[amazon box=”007174908X,0735201447,1118273052″]