When Intuitive Thinking is Wrong

report_400
Reddit

Should you avoid buying when the All Ordinaries is in a bear market?

I’ve seen this question quite a bit lately. And it’s understandable. People naturally worry about buying when the headlines are full of gloom.

Another question I often get is about shorting. Some ask if they should only take short trades until the market turns higher. Again, I can appreciate where this is coming from.

Intuitively, these questions make perfect sense — buy when the market is rising; short when it’s falling. But it isn’t always that simple.

I’m going to show you an email I received last week. The writer makes several points I want to address. Have a read below…

I am concerned about the potential for a severe market crash. Many of the world’s stock markets are well into their downturns, some have already dropped 50% from their highs, while the charts of those holding out look like they are at tipping point.

Accordingly, I will ease into the longs selectively. I’ll do a quick check on the fundamentals of each signal, and choose those I believe to be the most resilient to the ravages of a bear market. 

As the bear market appears to be approaching the bottom, I will start trading all the Quant Trader long signals in anticipation of the upward trend reversal. Once in profit, I will just follow all the Quant Trader automated long and short signals.

My questions are:

  1. If I were to enter the market just as it crashes, and before I have had time to accumulate much profit, would I still have a significant drawdown on my capital as the longs hit their exit stops?
  1. In light of the above, would it be safer, more prudent, and more profitable to simply go with the short trades while the All Ordinaries is trending down, and then switch to the long trades when the same triggers indicate a stock market reversal?

I think Quant Trader is fantastic. Your concept is brilliant in its simplicity. It liberates one from having to spend interminable hours manually analysing the fundamentals of hundreds of individual stocks and the macro-economic forces impacting them, by simply automating the following of the money flows. I am most appreciative that you have made this available to the man-on-the-street retail investor.

Member, John

Firstly, I’m grateful for the supportive comments. It means a lot to hear Quant Trader is helping.

But I want to focus on John’s other comments — they sum up the feelings I see in many emails. On one hand, people want to buy when opportunities arise. But they’re worried about a crash…and this holds them back.

John’s plan is to buy selectively. He only wants to purchase stocks he believes can hold up if the downturn worsens. This is a sensible strategy. I wrote about waiting for the right opportunities last week. It’s one of the most important things you can do as a trader.

But then John changes tack. His second question asks about the merits of only taking short signals. This is an entirely different strategy. It’s the sort of thinking I often see in a falling market.

You see, bear markets can cause traders to question their strategies. This often results in people abandoning an otherwise robust approach.

Let me address John’s two questions.

If I were to enter the market just as it crashes, and before I have had time to accumulate much profit, would I still have a significant drawdown on my capital as the longs hit their exit stops?

Long trades have a stop-loss of around 25%. So yes, if you bought a selection of stocks and the market crashes, all your trades could potentially hit their stops.

But that’s a worst case scenario.

It’s worth remembering that not all stocks go down in a bear market. Even in a tough year, some stocks can still do well. These are the ones Quant Trader is targeting.

Take 2015 for example. The All Ordinaries lost over 13% from its March high. But, during this period, Quant Trader still signalled 11 stocks that rose over 50%.

You see, Quant Trader doesn’t make an assessment of the overall market. All the analysis is at the individual stock level. Last year’s results show the benefit of this approach.

Of course, not every signal did well in 2015 — that’s why we have an exit stop. This is our escape path when things don’t work out.

There’s no way of knowing the timing of a major bust. You can sit on the sidelines for years waiting for something that might not happen. This can lead to many missed opportunities.

I believe it’s best to take opportunities when they arise. You then use exit stops to manage risk. Even if you do buy just before a bust, you have a plan to exit losing trades.

The biggest mistake I see traders make isn’t getting in at the top — it’s holding on all the way down.

In light of the above, would it be safer, more prudent, and more profitable to simply go with the short trades while the All Ordinaries is trending down, and then switch to the long trades when the same triggers indicate a market reversal?

This is a very logical question. Only trading short while the market trends lower instinctively feels right. But there’s a bit more to it.

As I said in my previous answer, Quant Trader’s buy signals generally did well in 2015 — despite the market falling. Someone focusing solely on the short side would have missed these.

Also keep in mind that shorting is not Quant Trader’s primary strategy. The system has historically made most of its hypothetical profits from buying shares.

You see, shorting strategies have a natural disadvantage. The most a stock can fall is 100%. But there’s no limit on how far it can rise. Gains on long trades can compound indefinitely.

So why trade short at all?

Well, shorting has a particular purpose. The aim is to buffer the portfolio during market downturns. This tends to smooth out performance over time.

Think of trading short as taking out insurance. It will typically be a drag on performance when the market rises. But it should lessen the impact of a bearish phase.

As I said, the aim of shorting is to smooth performance — not to act as a standalone strategy.

Bear markets are emotionally difficult times for many. The relentless negativity can lead to fear influencing your decisions. And this rarely produces good outcomes.

I find the best way to deal with uncertainty is to follow my plan. This ensures my trading remains consistent and unemotional. That’s the only way I want to trade.

Until next week,

Jason

Editor’s note: If you are concerned about the recent market volatility, here’s one thing you should do…

Check out Jason McIntosh’s Quant Trader advisory service. It’s a fully algorithmic trading system for ASX stocks. Quant Trader scans practically every company. I can just about guarantee you’ve never heard of many of these unique ideas.

If you’re not familiar with Jason, he was a trader at one of the world’s most powerful investment banks for nearly a decade. He’s seen dozens of market corrections and crashes. This experience is hard coded into Quant Trader’s algorithms. And the results speak for themselves.

So if you are at all worried about the markets…if you’re not sure when to buy or sell…I strongly suggest you look into Quant Trader now.

Try it. See if it makes sense to you. It could change the way you trade forever.

Jason McIntosh

Jason McIntosh

Jason is a professional quantitative analyst. Before he graduated in 1991 he joined Bankers Trust — a Wall Street investment bank — to be a trader. After Bankers Trust was taken over in 1999, Jason, already financially independent, co-founded a stock market advisory and funds management business called Fat Prophets. At 37 he sold his part of that business and retired. These days, he’s a private trader and system developer. In 2014 he launched the wildly successful trading service: Quant Trader.
Jason McIntosh

Latest posts by Jason McIntosh (see all)

Reddit

Leave a Reply

Be the First to Comment!

Notify of
avatar
wpDiscuz
Letters will be edited for clarity, punctuation, spelling and length. Abusive or off-topic comments will not be posted. We will not post all comments.
If you would prefer to email the editor, you can do so by sending an email to letters@dailyreckoning.com.au