There Are Two Types of Corrections

There are two major types of corrections:

1. A normal pullback within a bull market – this is a garden-variety 5-8% pullback above a rising 200-day moving average. Momentum stocks with the highest relative strength during the correction are likely to significantly outperform during a recovery.

2. Deeper 15% to 20% correction in a major index – this one characterizes with periods of massive forced liquidation when people and institutions sell not because they want to, but because they have to. These type of corrections often start below a flat or declining 200-day moving averages of a major index. Some of these corrections turn into bear markets, which last more than a year. The best performers during a recovery are usually the ones that were hit the hardest during the correction – the ones that are down >80% from their 52-week highs, the ones that were essentially priced for a bankruptcy, but managed to survive.

Based on the current price action, I believe we are in the first kind of correction. Act accordingly.

Choppy vs Trending Markets

Periods of great opportunities are often followed by periods of great challenges. Challenging market environment is not a market correction. As long as there’s clearly defined trend, up or down, there are many more opportunities than uncertainty. There’s never 100% certainty, so stop looking for it. There are times that are simply more challenging for traders. I refer to them as choppy markets. Choppy markets change direction frequently and shake out both overly active traders from both, long and short setups. Choppy markets frequently go above and below their 5, 10 and 20-day exponential moving averages.

The biggest troubles in trading come from overtrading in a choppy market environment. Those periods don’t last long. There’s only one cure for them – do less, trade less, use smaller position sizing. The goal is to keep any capital drawdown to a minimum and protect our confidence. Why is protecting our trading confidence so important? Because market environment constantly changes. Periods of choppiness are regularly followed by periods of great opportunities. If you lose too much of your trading capital during choppy markets, you are likely to second-guess yourself when a trending market comes around and miss on some great opportunities because of fear of further losses. Many traders are fearful when they should be bold and bold when they should be proactively taking gains and raising cash positions.

What to Do if You are Down A Lot on a Position

Traders protect capital by taking small losses. Investors protect capital by having a well-diversified portfolio or buying short-term puts on their large individual stock holdings when market conditions start to deteriorate.

By far, the most frequently asked question I get asked privately via email is some variation of “I am down 30% on such and such stock and I can’t take it anymore. Tell me what to do – take a big loss or hold?”.

I understand the precarious state of the situation. I’ve been there several times in my career. In this case, there’s no point of telling people that they should always use a stop; hope is not a strategy, always have an exit strategy; if you don’t know why you are in a  stock, you won’t know where to exit.

What I usually tell people is that the loss has already happened. Since it is in an individual stock, there are no guarantees that it can’t go lower or that it will ever recover to their break-even point. Now, it is up to them if it will remain just a loss or become a habit-changing lesson.

There is a difference between a drawdown in an individual stock and a drawdown in a well-diversified index. The latter is usually actively rebalanced every year and it tends to recover over time – some do faster than others.

The questions you need to ask yourself are:

1. How much money are you really comfortable losing on this one position? It doesn’t make sense to risk more than 1% of your capital per idea.

2. Would you buy at the current levels again? What is your stop if you do?

3. Why do you need to make money exactly in that name. There are thousand of liquid stocks out there. The odds are that at least several of them offer better risk/reward entry points at the time and have a better potential of making you money.

After a brief philosophical answer, I cut straight to the chase.

Your first loss is your best loss. Staying with a large loser has a detrimental impact on your health and well-being. You get obsessed with this one position and as a result, you miss on so many other good opportunities that the market generously provides every week.

What would I do in your situation? I’d take a the large loss and move on. Then I’d take a few days to recharge emotionally, review past trades, study winners and losers, talk to other traders that have been there.

Trading should be an enjoyable and profitable experience; otherwise, why bother?

 

An Example of a Failed Breakdown

There are many different ways to make money in the stock market. What they have in common is that each has its own sweet spot – an environment when it works best and delivers the biggest return on capital.

I constantly innovate and try different setups. I started my career with just one setup – the so-called post-earnings announcement drift, which buys tight consolidations in stocks that gap up on earnings. It has delivered consistent profits and I continue to use it today. Over time, I gradually added more ideas to my portfolio of setups until I reached a point where I have a good setup for each type of market environment – uptrend, distribution (topping process), downtrend, accumulation (bottoming process).

Here’s an interesting setup I’ve been experimenting with. A false breakdown – it happens when a stock breaks down to new 52-week lows, but its RSI reading doesn’t confirm it. This is often referred to as a positive momentum divergence. The goal is to enter when a stock goes back above its breakdown level and to sell near a declining 20 or 50-day moving average. In a strong bull market and near major market bottoms, such type of setups could deliver quick 20-30% in 1-2 weeks. My stop is usually the low of the breakdown day.

Keep in mind that not every positive momentum divergence leads to a reversal or profit. In some cases, stocks might continue lower for several days before they reverse. This setup doesn’t work during market downtrends.

1

Typically such setups work best near major market bottoms. Stocks tend to top individually, but most of them bottom as a group. I talked about this development here.

The Only Time to Safely Bottom Fish for a Stock Is …

VRX is down another 40% this morning, extending its drawdown to 85% from its 52-week high reached last summer. I am not familiar with VRX’s fundamentals and I am not going to argue about them. My point is strictly about technicals and sentiment.

Over the past few weeks, many have been pointing out to a positive momentum divergence in VRX – its price made new price lows in early March while its RSI didn’t. For some this is enough to put it on their watch list and wait for some signs of strength before entering on the long side. While it is true that momentum often leads price, price is the only thing that actually pays us. The delay between a positive momentum divergence in individual stocks and price reversal could be substantial or longer than most people could remain solvent and sane. Plus, this signal doesn’t always work. No indicator does.

sc-1

My friend Frank Zorrilla made a really interesting observation this morning:

$VRX is the reason why you don’t bottom fish, $NFLX back in 2012 is why you do…that settles it…

— Frank Zorrilla (@ZorTrades) Mar. 15 at 07:35 AM

NFLX also lost 80% of its market cap in 2011/2012. The difference is that then it spent multiple weeks in a tight, low-volume range, which is the ultimate sign of neglect. Then, it made a new 52-week high in early 2013 and it never looked back. It went up more than 400% in the next 3 years. You didn’t have to bottom fish for NFLX. You could have been “late” and wait for a fresh breakout from a consolidation and still achieved a substantial return. The best performing stocks in any given year are usually the ones that surprise the most. This means that they will often come from a place very few expect – they are likely to be widely neglected before and even after their major high-volume breakout to new 52-week highs.

sc-2

There is a time and place for each market strategy.

Stocks that make new 52-week lows in a bull market are usually there for a good reason. From my perspective, there’s only one market environment where it is relatively safe to try bottom fishing and the potential reward far outweighs the risk taken. It is during market corrections when the general market tests its momentum lows with some form of breadth divergence. In my book CRASH, I describe the five stages that a typical market correction goes through:

  1. The Guillotine Stage – fast sharp decline that last 1-3 weeks and leads to a 5-10% loss in major indexes and leads to extremely oversold market breadth readings. Volatility spikes through the roof during this stage and it stays there. Indexes close below their 200-day moving average.
  2. Short-term bounce that gains back 30-50% of the sharp decline in stage one. Such bounces often find resistance and reverse lower at declining 10, 20, 50 or 200-day moving averages.
  3. Choppy market environment, that gradually whipsaws both bulls and bears as market often changes directions and daily price ranges are extremely wide. During this stage, fear is gradually replaced by apathy and lack of interest in the market.
  4. A retest of the momentum low achieved in stage 1. There is usually some type of breadth divergence – indexes are piercing below their momentum lows but with improved internals – there’s a smaller percentage of stocks making new 20-day lows than in stage 1. If indexes cannot sustain bounce after this retest, we are probably in the midst of a bear market or a lot longer correction, at least.
  5. Recovery – correlations are very high at this stage. Indexes quickly reach overbought levels and stay there for a long time. Those who wait for a pullback, miss the boat.

Most stocks tend to top individually, but they bottom together as a group. Fishing for beaten down stocks that are down 80% or even 90% from their 52-week highs only makes sense in stage four of a typical market correction. Here’s a recent example.

1

2