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?