Good Day Rookie Bloggers! This week we are going to talk about the current market conditions that we are seeing and what it means for our trading. Although it would be great to believe that our trading systems will work in all market conditions this is not always the case or more aptly put, there are certain market conditions that allow our systems to thrive and then there are those who don’t fare quite as well. The question that pops up is “what do we do when the market conditions change in such a way that our systems become less effective or falter altogether. We will explore this dilemma and see if we can think of some ways around it.

So let’s talk about the current market conditions. There is a lot going on in the markets right now. We have 3 of 4 major indexes that are at or close to all-time highs. The Nasdaq is the strongest of the bunch right now and has been exhibiting the most strength for the better part of three weeks or so. The Dow and the S&P are solidly up at resistance. The only laggard in the bunch is the Russell 2000, or the small-cap stocks. This is the story of the indexes but it is not the whole story of the market. If we just looked at the indexes then one would think that everything is pretty bullish and we are headed much higher, however, if we look a little deeper into the indexes and the stocks that make up the market we may see a different story. When we look at the breakdown of the indexes, one can see that the major indexes are weighted quite heavily in a few equities and that strength in those equities can skew the charts to make them look stronger than we believe. An example of this is the breakdown of the S&P 500. If you look at the sector breakdown below you can see that the index is heavily weighted in certain sectors and then taking those stocks within those sectors you can see how the index can seem skewed at certain times.

We can see the S&P 500 is heavily weighted in Tech and the top 5 holdings are AAPL, MSFT, AMZN, FB, and GOOGL. The weighting of these stocks goes from 5.5% down to 2% for GOOGL. This makes us a large amount of the index and if these stocks are showing strength then usually the index also looks good because it would take a majority of the other stocks to be down to offset the bullishness of these five. So if the indexes are skewed then how do we recognize this so that we have an accurate picture of the market? We could look at all the stocks in a particular sector to see what is really happening but that would be rather time-consuming and most likely a waste of time. Instead, there is an indicator called the advance/decline line and it can fill in the missing pieces of the puzzle when it comes to looking at the current market conditions. We can see this indicator on Think or Swim by entering the symbol $ADD. Take a look at the chart below and you can see what it looks like.

This indicator tells you how many stocks are going up versus going down on the day. If it’s red then more are down on the day and if it green then more are up on the day. So looking at this chart and seeing that red candle and seeing the number -496 means that there are 496 more stocks down on the day than up on the day. We could not necessarily see that just by looking at the indexes. So the current conditions are not as rosy as the indexes might seem and you may see this in your own portfolio or you can see that here as well. You may also see these particular conditions when you are scanning for particular opportunities. If you are combing your watchlist or scanning for decent trade setups and you are not finding them then it can be a function of these types of conditions. So what do we do if we cannot find setups we like for our regular systems or we find that our favorite stocks are either greatly overextended or not quite set up from a pullback perspective?

If these are the conditions we are running into and we find our regular systems and setups are not optimal then there are really only a couple of wise choices to make. Pushing a trade setup will most often end up in a losing position and our job as traders is to avoid exactly that. The only sane choices are to be patient and wait for the proper setup and this means sitting on your hands until the markets resolve themselves and present better opportunities, This is problematic for a lot of traders as we all want to be active and making money all the time. I would recommend that you resist the urge to react like that as it will most likely result in a drawdown in your trading capital. The only other choice that makes sense is to use trades and strategies that result in better opportunities in the current conditions. We have a pretty good example happening right now of this second choice. Right now a lot of the strongest stocks are overextended and the weaker ones are not really set up that well for us to participate in so if we cannot get the desired delta trade because the equities are too stretched then we can switch to a trade that can take advantage of time instead of direction. This can mean transitioning from directional trades to cashflow trades like covered calls, naked puts, or credit spreads. If you believe there may still be some upside as well as working the time angle then you can transition to poorboy covered calls or diagonal spreads that can give you the best of both worlds.

The key takeaway here is that we have to understand what the current market conditions really look like and then matching our trade types to those conditions. This means being attentive and flexible when the market is changing from one set of conditions to the next. It may also mean spending the time to learn and categorize the different market types.

The best traits of trading are patience, attention, and flexibility. Working on these skills on a regular basis is a great way to become successful in your trading endeavors

Trade Well,

Coach “Old Money” Holmes