Don't Get Caught in a Bear Trap

NEW YORK (FMD Capital Management) -- After a big year, the market has been decidedly weak so far in December. Despite an upbeat jobs report, we are seeing a consolidation in prices across most of the major indices. This consolidation could be healthy, given the height of the market and the incredible run that it has undergone since we began the year. However, it is also going to give some hope to the bears that we will see at least a short-lived selloff before we close the books on 2013.

The percentage of bears is near historical lows. When you add in the potential for tax-loss selling and profit taking before year end, it starts to become easier to convince yourself that the market may already have peaked.

I know more than a few investors who are licking their lips for the chance to indulge in the guilty pleasure of shorting the market from the highs. Those that have missed the rally will be itching for an opportunity to make up that money on the downside. With the advent of inverse ETFs, like the ProShares Ultra Short S&P 500 ETF (SDS), this endeavor has never been more accessible to the average trader.

Personally, I am not a huge fan of trying to call a top in the market or looking to employ leverage to enhance returns by betting against the crowd. Experience has taught me that most retail investors find themselves entering inverse positions at the wrong time and for the wrong reasons.

I have met only a handful of steely traders in my career who have the time, tools and discipline to consistently profit by shorting stocks. These traders have the uncanny ability to set aside emotion and look at an opportunity from a completely objective perspective. In addition, they are quick to cut their losses if the tide turns against them.

More often than not, I talk to investors and clients that end up getting caught in a bear trap that lops off a portion of their hard-earned nest egg. For those who aren't familiar with the terminology, Investopedia defines a bear trap as:

"A false signal that the rising trend of a stock or index has reversed when it has not. A bear trap prompts traders to place shorts on the stock or index, since they expect the underlying to decline in value. Instead of declining further, the investment stays flat, or slightly recovers."

When I examine a one-year chart of the SPDR S&P 500 ETF (SPY), I am reminded of why I try to avoid using inverse ETFs in my client accounts. There were several instances of 2% to 5% pullbacks in 2013 that ended up being buying opportunities rather than shorting opportunities.

In addition, if you were not careful to put a tight stop loss on your inverse trade, you were probably quickly stung for double-digit losses. Those types of mistakes can hinder your total portfolio performance even during a stellar year like 2013.

Some Guidelines to Follow for Shorting the Market

  1. Make sure that you are using a tight trailing stop loss whenever you are entering a short position. A small loss is much easier to make up for than a big loss that can set you back months.
  2. Shorten your time frame when using leverage or inverse positions. Instead of months or quarters, you should be thinking in terms of days or weeks for entering and exiting positions. Stay nimble and take profits when possible.
  3. Use smaller position sizes when you are shorting the market as a way to limit your exposure. Your allocation size will determine how much you are willing to risk.
  4. Remember to stay as balanced and unemotional as possible when shorting the market. Don't get overly confident when things go your way or too depressed when they don't. Keeping your emotional capital -- confidence -- intact is just as important as preserving your investment capital.

The most negative of bears will always try to convince you that the next 2008 financial crisis is right around the corner. Maybe. But I would prefer to transition my portfolio to cash, fixed-income or other non-correlated holdings to ride out that kind of storm. I won't be overly concerned about a new correction or bear market until we see a dip below the long-term moving averages.

For now, I am continuing to monitor the price action of the market and actively looking for new income and growth opportunities.

At the time of publication the author had no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

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