Tales of a Technician: When Bear Markets Strike
September 20, 2021
It’s getting ugly out there. The S&P 500 is now 5.3% off its highs, which may not sound like much but is officially the largest pullback of the year. What’s more, it’s masking the damage transpiring beneath surface. There are other sectors/industries that are faring far worse. Some are even in a bear market.
I’m taking damage today like any other trend-follower. Dodging every downturn isn’t possible. If you want to capture the market’s upside then you must be willing to participate to a certain extent on the downside. This is one of those times. It doesn’t mean it’s easy, nor fun. But it is necessary and unavoidable.
During episodes like these, it’s worth reminding us all of the best practices for handling corrections.
Mindset Matters
First, mindset is everything. Most corrections arrive out of the blue and have the potential to send your emotions to the moon. To avoid this, preparation is everything. Experience helps too. The first few corrections were shocking to me. But after you’ve seen dozens of them, the shock factor wears off. Eventually, you realize losses are unavoidable. And, if you have good trading systems – they’re temporary. No pain, no gain, as they say.
I think the following Mike Tyson quote is instructive:
“Everyone has a plan until they get punched in the mouth.”
A plan that doesn’t work when you get punched in the mouth isn’t a robust plan. You must prepare for favorable and unfavorable outcomes. What if this 5% whack is just the beginning? What if we end up 10% or 20% off the highs? Do you have plans in place to survive? Do you know what the end game of your positions is? I hope so! Though I highly doubt we’re going into a protracted bear market, anything is possible and it pays to be intellectually flexible.
If there’s one thing I’ve learned and relearned over the years, it’s that you must not allow forces outside of your control to determine your peace of mind. Feeling like garbage every time the market falls is a terrible way to go about being an investor. It’s draining and unsustainable.
I don’t want you to think I don’t feel some pain when markets decline. I do. I’m human. But the size of the impact is far less than it used to be.
Position Sizing Matters
My ability to remain stoic in situations like this lies in large part with proper risk protocols. I assure you that if my portfolio were down 30% over the past two weeks that I would be anything but calm. But I don’t trade that way. It involves too much leverage and it’s unnecessary for me to achieve my goals.
The size of your current drawdown is a function of two variables: risk per trade and number of trades.
If you’re swing trading with 1% risk per trade and 8 bullish positions, then the most any bear raid can steal from you is 8%.
Where things get trickier is when you have long-term stock positions (or naked puts/covered calls) where you’re not using stop losses. In those cases, it’s a little trickier to determine your max pain threshold because it really depends on how far the market declines.
You can use a risk graph and model your entire beta weighted portfolio to forecast the damage though.
Planning Matters
You never want to wake up on a day like today and be wondering, “what do I do!?” If you are, then it means you failed at the most important assignment you have when trading and that is to PLAN YOUR TRADE ahead of time. My answer to this oft-repeated question is always the same – You should simply follow your plan. For instance, some of the trades we’re tracking in the Team Phoenix lab are being tested today. In many cases, our short puts are moving ITM and we still have about a month remaining to expiration.
If my plan was to exit when my short strike was breached, then I’d be stopping out of positions today.
If my plan was to scale into additional contracts, then I’m waiting for an appropriate trigger.
If my plan was to ride to expiration and allow assignment, then I’m playing golf. Might I end up with an underwater stock position come October expiration? You bet. But I’m assuming this is a stock/ETF that I like and have the utmost confidence will eventually recover. So why should I freak out over a drawdown that will likely prove temporary anyway?
Every single market correction preceding this has been a buying opportunity. This one will prove no different. It’s only a matter of when and whether you know how to take advantage of it.
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