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.
