This column was originally published on RealMoney on Nov. 9 at 12:08 p.m. EST. It's being republished as a bonus for TheStreet.com readers.
The broad market has been trending higher for more than three months now, but taking advantage of the rally has been tougher than it looks for many traders. Here's why.
Since the August breakout, the
Nasdaq 100 Trust
has carved out just eight strong rally days.
The other 52 sessions, or 86% of the total, have been marked by churning activity designed to shake out positions on both sides of the market.
These volatile days have picked more pockets than Oliver Twist on his best day.
The latest shakeout came on Wednesday morning, when a post-election gap down triggered waves of stop-losses and stomach aches. Though the market recovered well after the bull trap was sprung, a fair share of market players were forced to spend the majority of the session dressing their wounds from opening losses.
It's natural to believe in the market's upward bias, even though it's a path to chronic underperformance. In reality, all financial instruments move in both directions over time. Simply stated, you won't survive as a yo-yo trader, giving back your hard-earned gains on every downturn, whipsaw or head-fake.
Keep Profits in Your Pockets
Traders get conditioned to chase breakouts and let positions run after big rallies. This herd mentality undermines their ability to hold on to profits when more challenging conditions take control of the ticker tape. In response, we need to apply defensive strategies to ensure that those hard-earned profits stay in our pockets, where they belong.
The first challenge in defensive trading is a psychological one. We find it almost impossible to stop taking the types of positions that yielded profits for two, three or four months, even when they stop working in a changing environment. This is Pavlov's dog syndrome, where we salivate right on schedule every time the dinner bell rings.
Profits rely on market inefficiency. These trading edges are moving targets that disappear when the crowd piles into a popular strategy. It's the primary reason why bull traps appear with great frequency after long rallies. The correct response to waning inefficiency is to shift gears and find trades that respond to the next wave of market activity.
What does that mean at this particular market juncture? Traders should consider longer-term pullback plays and risk-controlled short sales on obvious underperformers, despite the rising market. In fact, avoiding most momentum trades makes good sense until the latest series of whipsaws dies down.
Standing aside is the next logical step to building a defensive strategy. Cut your trade frequency in half and see how that affects your bottom line for a week or two. You're obviously on the right track if fewer trades equal more profits. Also, your time spent as an observer rather than a participant will give you a more objective view of price action.
A cautionary approach really pays off when the market turns and moves lower without warning. When that happens, you can take all the bucks saved by sitting on your hands and put them to work buying strong stocks that have pulled back to considerable support. Of course, this takes a lot of discipline and extreme patience.
Do you get nervous after every buying surge or unexpected piece of good news, afraid of missing the next rally? If so, there's an excellent chance you're buying a lot of highs and selling a lot of lows these days. Many traders have become deathly afraid of missing the next big move, forcing waves of ill-advised positions.
Take the middle ground if you absolutely can't avoid the temptation to chase upticks these days. Pick up the minimum numbers of shares using a tight stop-loss, keeping plenty of cash in reserve. In this way, you can take advantage of the buying pressure but respect the likelihood that you're stepping into a bull trap.
Tips of the Trade
Lower your overall exposure and find less-volatile stocks to trade. This means walking away from four-letter stocks and finding slower movers in less active sectors, such as utilities, telecom or country-based exchange-traded funds. It might also be a good time to find new plays in food and consumer durables.
Keep an eye out for rotation. Market players move money out of hot sectors all the time, looking for better places to park their capital. Decipher where this cash is headed, and you've found a considerable trading edge. Curiously, beaten-down sectors with the worst-looking charts usually become the best rotation plays in shifting markets.
Stop imagining big moves and learn to take smaller profits. Understand that every position you're holding is at major risk. Then learn to take profits early and buy back stocks at lower prices.
Lower your overall trading size. Traders get comfortable making big plays when markets move higher. But risk increases dramatically during churning periods, and you can lose a lot of money if you're overmargined. Smaller size also lets you survive stop-gunning exercises that are common during whipsaws and shakeouts.
Test the waters when you believe the market is near a turning point. Pick up a few shares and add to them as they move in your favor. But take losses immediately when you're wrong and then wait patiently for another opportunity. Eventually you'll get it right and make back the capital you lost in the small excursions.
Finally, it's time to get back into short-selling. Shorts get blown out of the water when markets move substantially higher over time. But this cleansing process empties the playing field, making this classic strategy more reliable, even when the rising seas appear to be lifting all boats.
At the time of publication, Farley had no positions in any of the stocks mentioned, although holdings can change at any time.
Alan Farley is a professional trader and author of
The Master Swing Trader
. Farley also runs a Web site called HardRightEdge.com, an online resource for trading education, technical analysis and short-term investment strategies. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Farley appreciates your feedback;
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