How to cope when the markets conduct a hand brake turn with very little in the way of warning and how to exercise patience

Jan 28 • Between the lines • 1889 Views • Comments Off on How to cope when the markets conduct a hand brake turn with very little in the way of warning and how to exercise patience

shutterstock_160916111Regular readers will notice that we’ve used the strong bullish momentum move on the DJIA, witnessed breaking to the upside on or around December 18th, as an example of how fundamentals work in our markets. At the end of the FOMC meeting in December the Fed announced that the ‘taper’ was now on. They announced that the monetary stimulus would be reduced by $10 billion in the month of December. As a consequence the markets rallied in an unbroken fashion, from an approximate level of 15800 on December 18th, to circa 16600 at January 9th, printing new record highs on the Dow along the way.

Now we’ve used this example to highlight several trading related issues. But the main reason we’ve used it recently was to remind traders that whilst price ‘reacts’ to certain levels, particularly round numbers and SMAs such as the 200 SMA, for the majority of the time, when we witness a violent change in sentiment on our charts, it’s as a direct result of a major fundamental policy announcement, or a high impact news event. And they didn’t come bigger than the reduction of monetary stimulus into the USA economy late December.

We’re once again using the DJIA as a trading example in this article, but for entirely different reasons. The DJIA experienced a major sell off last week and analysts, investors and market commentators were left scratching their collective heads as to why. There were several candidates as to why the market suddenly sold off, but no definitive single reason…

  • Emerging markets could have been to blame and nowhere was that turmoil more evident than in Argentina, where the domestic currency of the peso lost up to 18% of its value versus the USD during Thursday’s trading sessions.
  • The impending debt ceiling issue in the USA could be playing on investors’ minds, it’ll return as a highly charged topic for debate mid-February.
  • Were we witnessing profit taking post Xmas, as traders are reluctant to close positions before the end of the year, especially loss making positions?
  • Earnings season hasn’t provided many fireworks in the USA either, so many investors may have decided to cash out and take their profit ‘off the table’.
  • And with the two day FOMC meeting due to commence on Tuesday this week investors could be fearing that the Fed will maintain its taper, despite much of the recent data regarding the USA economy being ‘soft’, which may cause the index to fall even further.

No doubt there is plenty of data that retrospectively points to why the markets in the USA sold off and it’s that sell off, demonstrated by the technicals, that we want to concentrate on in this analysis.

We thought it’d be a useful exercise to talk and walk through the break to the upside from December 18th, how we managed this single trade, especially in relation to how we effectively used trailing stops to ensure that we locked in profits as the trend developed. As is our habit we’ll refer to the most commonly used indicators that feature heavily in our “is the trend still your friend?” weekly analysis conducted on a daily chart.

Far too often we enter the market perfectly and according to our plan, when our high probability set up aligns, but we fail to exit as per our plan, whilst also failing to lock in the profits as the move develops. It’s this use of stops (that’s crucial in this situation) that we want to concentrate on in order to illustrate how we can retain a significant amount of points’ profit. As we’ve stressed in recent articles we won’t pick the top and bottom precisely, what we’re looking for is to take significant ‘chunks’ out of both moves, the bullish break to the upside and the recent break to the downside, which may develop into a trend, particularly if the FOMC meeting on Tuesday and Wednesday of this week produce a decision that leads to a further sell off.

The entry on December 18th and the exit on January 9th

According to our rules we’d have entered the break out on December 18th. PSAR appeared below price, the DMI became positive, whilst the MACD (despite being negative) made higher lows. Stochastic lines had crossed on the 10,10,5 adjusted setting, whilst the RSI moved aggressively through the median 50 line. We’d have exited the bullish momentum trend move, as per our rules, on January 9th as the PSAR appeared above price. We’d have trailed price by using the PSAR (two days behind the current price) and the total pips gained should have been considerable for any traders following our advice and trend trading method. Circa five hundred points as a minimum, a tremendous start to the year if you’re an ‘indices trader’.

Then we crucially sat on our hands for close on two weeks whilst awaiting our set up to occur in order to take the next trade. And that sitting on our hands patiently as swing traders, whilst waiting for our set up to occur, is absolutely critical ensuring that we’re not giving points and profit back to the market. Enter too quickly and that skilfully earned profit can be easily given back.

Once again we must remind traders that when we’ve experienced such a huge move (bullish or bearish) as we did up to the 9th January, then before we enter in the opposite direction, we must ensure that all the indicators are aligned as we can often experience false readings. There is little point in traders becoming excited at the first opportunity to enter in the opposite direction as we may temporarily experience a classic Fibonacci retracement, for price to then continue in the original direction.

However, we’ve experienced a classic pattern with the DJIA over the past month with the momentum of the move decelerating on January 9th as the energy and sentiment appeared to stall. This was evidenced by 16,500 being breached, but thereafter, for several days, acting as a magnet for many of the orders that were no doubt clustered in the market; buy, sell and take profit limit orders.

The current situation

Finally our complete signal to enter, confirmed by our cluster of indicators, arrived on January 23rd. The PSAR appeared above price; both the MACD and DMI were negative and making lower lows using the histogram visual, whilst the 50 day SMA was breached, as was the lower Bollinger band. As we entered the short trade we placed the stop at the high of the Heikin Ashi candle on January 22nd.

And that’s where we currently are, close on 350 pips up on this short trade and naturally with one eye on the FOMC meeting on Tuesday and Wednesday, with an announcement on further tapering due, we’ve got to very carefully manage our position. We’ve trailed the stop by using PSAR and locked in 200 pips profit. We’re now in a ‘comfortable’ position in relation to our trade knowing that the next two days has the possibility to surprise. If the market reverses dramatically and takes out our stop, then potentially we’ll be in a position to follow the new bullish trend but having gained 200 points. And if it is a new bullish trend then it’ll probably be as a consequence of the FOMC meeting and the fundamentals decisions made. If so then we could see the previous record highs revisited.
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