7 Ways To Trade A Declining Market

7 Ways To Trade A Declining Market
By Larry Connors

TradingMarkets.com
August 13, 2004   5:00 PM ET


The More Things Change, The More Things Stay The Same

"I Thought He Was Permanently Banned!"

Was CNBC actually interviewing Henry Blodgett on Friday asking for his opinion on the Google deal??? Naahhhh, I must have imagined it...


Trading A Declining Market

With the SPX, the NDX, the SOX and the XBD's all below their 200-day moving average (all four have been below for a few weeks), the path of least resistance will be to the downside until proven otherwise. Hopefully, this condition is short-lived and we will again soon see a healthy market. But, in case we don't, here are some ways to help you get through a weak market.

1. Bear markets are usually associated with higher volatility. This means stocks will move faster than they do in a bull market. Just look at the Nasdaq over the past month and you see how quickly prices imploded. And, when we bounce, the move up will be much quicker than normal, especially because the buying will be fueled by short covering. Yes, it's great when things move in your favor in a bear market because the gains come quickly, but it hurts more when prices move against you. How do you protect yourself from this volatility? Usually it's done with smaller position size. By taking positions that are a bit smaller than what you took in 2003, you'll lessen the daily volatility of your portfolio. Some traders are not looking to lower the volatility, especially when they are short and the gains are coming so quick. But, it's only a matter of time before a bounce occurs and many times these bounces are very sharp. Weeks worth of gains evaporate in a few days. If you want to see an example of this, look at charts from late July 2002.

2. The better gains will always come from shorting at the correct time after the bounces. Wait for these bounces, short into them as prices begin moving lower again, and use proper stops to protect yourself in case the move is actually a transition back to the bull.

3. Further to number two. You can't blindly short any bounce. Use statistically backed patterns to guide your trading. Three up-closes in a row combined with a put call ratio under .50 (with the market under the 200-day MA) will stack the odds in your favor that the bounce is now short-term overbought and a new round of selling is potentially near. Three consecutive higher highs combined with three consecutive days of advancing issues greater than declining issues is another. Four higher closes in a row plus a Window setup (see Genentech (DNA) from Friday) is one more. I can go on and on with these combinations. The key is for you to be patient and wait for them.

4. Oversold markets can and will become more oversold. Attempting to buy an oversold condition when the markets are below the 200-day moving average is a very, very tough game. It's even harder than shorting into a bull market. Don't dip your toes in without strong confirmation!

5. Clues To A Bottom: You'll see a bottom (short term and possibly longer term) when the bad news is being shrugged off and the market rises. Crude will rise, terrorist threats will occur, a major company will say that business is poor, and the market will yawn. When that happens, it's a green light. When they can no longer take the market down on bad news, it means the selling, at least for the short term, is over.

6. More Clues: I've said this many, many times -- As the Semis (SMH) and the Brokers (XBD), go, the market will go. They lead. Always have and likely always will. If they start rising, the market will likely too.

7. Final Point: This one is going to be a bit controversial. But, we have more than ample statistical evidence to back this up. Looking at over 20 years of price data, the stocks that have outperformed the market when we've moved off bottoms, are the Blue Chip quality stocks that have been beaten down the most. Statistically, these stocks, as whole, have far outperformed the averages. Buy quality and buy it cheap. And interestingly (and here's where it will get a bit controversial) the next best gains have come from stocks that are extremely low-priced. An example is to think back to last Spring and look at the annual gains that were recorded by stocks that were originally trading at 1, 2 and 3 dollars. Most of these companies were internet companies but other post-bear markets have seen the same behavior.

I'm personally not comfortable with the low-priced scenario, but if you are very aggressive, you may want to look at it when we transition higher. But, I am very comfortable with the first scenario. Buy established quality (S&P 100 companies are a good place to start) and buy the ones that have been beaten down the most. Not only does it make sense, the statistics more than back it up.

Coming To TradingMarkets

In case this downtrend is prolonged, there are certainly additional ways to take advantage of declining markets. Beginning August 20, we're going to be publishing a 6-week course entitled "How To Trade In A Bear Market." The course is free to all TradingMarkets members.

Have a great week trading (and if you have any question on your trading please e-mail me at lconnors@tradingmarkets.com)!

Larry Connors