Don't Get Fooled Again

 | Aug 23, 2011 | 8:33 AM EDT
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"The pessimist complains about the wind; the optimist expects it to change; the realist adjusts the sails."

--William Arthur Ward

For the second straight day, the market is set to open strongly. It didn't work out Monday as almost the entire move disappeared by the end of the day.

Flat but benign news flow, some better data out of China, weaker gold and optimism that Ben Bernanke may ride to the rescue is giving the bulls some hope this morning.

A sharp bounce after a downtrend isn't surprising. In fact, it is almost inevitable as the market usually overshoots in the short term and needs to readjust before the overall trend continues.

The key to dealing with bear-market bounces is to make sure you treat them as just that. Folks are so relieved to see some green on their screens that they believe that the worst is over and that it is clear sailing to the upside. We saw a good example last week with a number of positive days on light volume that excited many bulls, but they found themselves trapped when things quickly rolled over again.

One of the challenges of trading oversold bounces is that you won't find the sort of technical chart setups that you would normally see in an uptrend or a bull market. Most everything has broken key support levels and is tending down.

Many trend traders simply won't buy stocks that are below the 50-day or 200-day simple moving averages. They see too much overhead resistance and the trend running the wrong way and have no interest. The whole idea of trend trading is to ride stocks when they are moving up; a bounce that lasts a few days does not provide the right conditions for that approach. This trend-trading approach doesn't allow much flexibility in one of these aggressive oversold bounces that occur within downtrends. You have to come up with a different approach if you want to participate.

The most important consideration when trying to catch oversold bounces within a downtrend is time frame. By far the easiest mistake is to let a short-term trade for a quick bounce turn into a longer-term investment when things don't go as planned. There is a tendency to rationalize holding a stock because it is a good stock and is sure to do well in the long term. Before you know it, you are loaded up with stocks that continue to struggle as the overall downtrend continues.

The moral of the story is to be disciplined when playing bounces and not let a trade turn into something else. Have a clear plan and if it doesn't play out, get out.

The other important consideration when playing these sorts of bounces is to have a plan for taking profits.  I always end up selling too early and feel a bit frustrated when the bounce goes higher than I anticipated, but it is surprising how often the quick flip turns out to be the smarter move.

The hardest part of playing counter-trend bounces is finding the right vehicles. Many market players will gravitate to some of the big-cap favorites, Apple (AAPL), Priceline (PCLN), Baidu (BIDU) and the like, simply because those are the go-to names of many aggressive funds. The momentum can build quickly in these names when the market holds and they will feed on themselves, so they can be very good bounce vehicles.

Another approach is to focus on stocks with good fundamentals. I tend to favor small-cap names that have been punished simply because they are illiquid. They traded in the first place simply because buyers were standing aside and panicked sellers were forced to sell into the abyss. These stocks can come back quickly when the market starts to focus again on individual stock picking, but the lack of liquidity cuts both ways.

We'll see how this morning's bounce holds, but I'm looking for short-term plays. There is no way I'm going to jump to the conclusion that the downtrend is over, though short-term relief seems likely.


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