On April 25th, in my Wrong in the Best Way episode, we talked about using Fibonacci extensions to determine when a market is too extended to the upside and needs to take a breath. While in this instance, the extended state of the market went on for seemingly forever, it’s still critical to know the market is extended… so you can take action, especially because you never know exactly which day the pullback will come.
This Sunday, May 5th, as many of you likely saw, the Dow was down almost 500 points at one period during the Sunday evening futures session due to a series of tweets from President Trump about the tariff wars with China. I’m sure many of you were looking at this news, and thinking about the impact it would have on your portfolio, and what you could do.
What type of action can you take in an extended market to protect yourself from the inevitable — the day the market finally pulls back?
Here are four methods I consider, the ones that I choose, and why…
1. Lighten Up: As a trend follower, I’m pretty much always long. Why? The stock market has been in a bullish trend the majority of my trading career, and I like to stick with the path of least resistance. So when the market becomes extended to the upside, I’m in profit taking mode and only adding select new trades. I think about it as a percentage of risk. Now, I’m an aggressive, directional trader. So when the market pulls back (like it has the past couple days) and I begin adding longs, I’ll go up to 60% of my portfolio allocated in directional trades to the long side. This is a lot more than ‘recommended,’ but I like to think I know what I’m doing. When I was first starting out, my maximum risk allocation was 20% of my portfolio. Now, 10-20% is my lower end of risk allocation when the market gets extended.
Market Cycles
Here are some examples for how I personally allocate my risk. Please note these are NOT recommendations, this is what I do with my own account. Risk Allocation Examples:
| When Indexes are at the mean | When indexes are at the mean, in a squeeze | When indexes are almost extended | When indexes are extended |
| 20-30% cash invested, looking for new trades as it trades higher | 30-60% cash invested, continually adding new trades as it trades higher | 20-50% cash invested, slowly taking off trades as they make extensions | 10-20% cash invested, with most trades taken off and waiting for new opportunities |
2. Hedge: I don’t hedge very often, but it’s a strategy that you can employ if interested. Why? Because, for the most part, hedges are meant to lose money. Yes, they’re right sometimes, but if you add up all of the times you were hedged and the market continued higher (as this market has, for the most part, been incredibly strong to the upside) the one time you’re right on the hedge, it doesn’t usually make up for the losses.
3. Short the Highs: One of the most common questions that I get is something along the lines of, “If you think the market’s going down (insert name of strong stock here — AMZN, MSFT, NFLX), why not short the stocks you just traded to the long side?” Reversion to the mean trading is what this is in reference to, and while I do realize that it’s a viable strategy, it’s just not one that I employ. Why? Because when I’m focusing on being bullish Amazon, or Microsoft, I never know exactly which extension target it’s going to. Sometimes it pauses at a retracement, sometimes it hits the first target, and sometimes it hits the second. It’s a lot easier to take profits on the way up, at various levels, than it is to try and short some of the strongest stocks out there and likely get your face ripped off. For me, shorting strong stocks may work every now and then, but for the most part, it’s a losing game, and I don’t employ this strategy.
4. Trade Futures: Trading futures is generally my favorite way to go about ‘hedging’ because you can day trade futures, without having to constantly be hedged. This way, on those days where the market gaps down and rolls over and dies, you have the skills and ability to make money to the downside. You can do this without having to constantly have a hedge on that usually loses money. If you’d like to learn more about trading futures, check out my beginner’s class I taught last year with futures pro, Raghee Horner. Check out the link here.
Why do I pick lightening up and trading futures?
These are the two that work best for me. For the most part, even on down days, I trade longer-term, swing setups. Even if they pullback for two days, the idea isn’t completely blown. It’s just fluctuating and down for a day or two before it comes back. Yes, some setups are blown and gone forever, that happens as well. But, ideally, when you lighten up because of market extensions… and you have the ability to trade futures to the downside of the market when the market is rolling over, you’re able to get through those crazy days.
As of right now, I see the pullback as almost done, but I’m watching the market internals carefully to tell me which way the intraday price action’s going. In this market, I look at pullbacks like this as buying opportunities, and I’m just waiting for the first signs that it’s over to begin adding longs.
Which strategies do you employ when prepping for down days in the market? What indications do you use that give you a hint of a potential pullback? What would you like to learn more about? I’d love to know.
I agree with not shorting stocks on a move up because as you say you never know how high they go. If anything I short the indexes/futures like you do…
Agreed – the reason why I select specific longs is because they have relative strength. It would be counter-intuitive to short them. Though, I do have to say, if it was a day trade, I wouldn’t mind it.
It’s usually easier to short indexes because you won’t have that one, news related short event that will rip your face off 🙂
Have a great day!
-Danielle
My strategy is to look for strong stocks that don’t gap down as much as the rest of the market. For example, today I noticed AYI held up very well between the mean and 1 ATR. It didn’t go down to the lower ATR levels as most other stocks. At the end of the day I bought some June calls on AYI.
I watch other strong stocks (Phoenix stocks or Bullish Chaikin stocks) go down to their support levels, most of them to their lower supports. Depending on what the markets will do tomorrow I will then jump in again in new trades.
I also bought calls on XHB this morning, a little early, but they held up pretty good. They pulled back to the mean and at the end of the day started going up again.
I have to watch myself jumping in too early sometimes. A little more patience goes a long way.
At the day’s end, I also bought some share of ELLXF, a quality cannabis stock that I have been watching for a while. It held up very well today. Excellent news has been transpiring about this company in the last two days, news that has not been published in the main news announcements on TD Ameritrade. It’s news about a major rollout at one of the country’s biggest grocery chains at this very moment. One of the better cannabis/CBD companies.
I have been a member for a while now and have taken several classes of yours as well as the small account that JC is teaching. I remember you spoke of your beginnings and the techniques you used to build up a small account. I do work full time but hope to employ better techniques to be more consistent.
Bobby Grissom
I would really really like you Gus at Simpler Options to add text to all of your voice in the chat rooms and in video. I am severely hearing impaired so it is easier for me to read the text instead of listening to your voices. All so I am sure that those who already belong to Simpler Options. If you had text we could be in the chat rooms and be able to follow everything being said. Especially when in meetings or even at the doctors office.
Hey Bobby,
Thank you so much for your suggestion. I think that is a great idea. I will send it to our developer and see what he can do. I personally love captions, etc while I’m watching tv so I can catch everything being said, especially when the volume needs to be low.
Have a great day –
Danielle
Hey Steven,
The techniques I used in the beginning were primarily premium selling on high beta stocks that maintain their options premium with out of the money strikes. This enabled me to sell premium, out of the money and outside of the expected range, for an acceptable risk/reward. Now, this is not the same as selling 1:1 risk/reward, at the money premium, but for someone who is working full-time or just doesn’t want to watch the markets all the time, these strategies are low maintenance and high probability. Though I’ve gone away from using this as much, since I am more active now, I’d be happy to discuss it more in the future.
Have a great day –
– Danielle
Trading the NQ futures is like riding a wild mustang in a rodeo with no harness to grab onto!
What is your favorite market to trade futures? NQ, YM, ES?
JC
Hey JC –
I personally like the S&P futures. The Nasdaq can be a bit wild, and while it’s less dollars per tick, since it moves so fast, it can be crazier than trading the S&P. However, it honestly depends on what I’m trying to do, and I rotate between the S&P, Nasdaq and Dow. If I’m shorting, I want the weakest link. So, if it’s the Nasdaq that day, that’s what I choose. If I’m going long, I want the strongest. Lately it’s been the S&P. Each one has their own nuances but I find the S&P easiest because of the key psychological values and it works really well with Fibonacci.
Hope that helps!
Danielle
Danielle: Thanks very much for your explanation of how u use the EMA lines to judge you depth of pullback and for your risk mgmt. chart. Your experience means a lot to us less experienced people.