Be Careful Playing a Bounce

 | Nov 15, 2012 | 7:40 AM EST  | Comments
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"Perhaps all pleasure is only relief."

-- William S. Burroughs

Few things are more seductive in trading than trying to catch a  bounce after we have suffered a particularly nasty breakdown. It is human nature to look for some relief after suffering pain, and the longer the pain continues the more confident we become that something positive will soon occur.

The recent breakdown has been much more severe than anything the market has seen in a while. Not only have we broken through a number of key support levels but we finished near the lows of the day for six straight days. It is often said that we tend to close weak in a bear market, which has certainly been the case lately, although we still are not technically in a formal bear market.

Sooner or later markets that are stretched this much to the downside will snap back as traders self-fulfill a bounce. Typically, they look for someone else to start the move, and once they manage to hold things in positive territory, the buyers start to pile in and the bounce is on.

One of the reasons that so many traders are anxious to play a bounce within a downtrend is that these moves are often quite substantial and come quickly. The biggest bounces almost always occur within downtrends because market players are not well-positioned for them and there is so much anxiety about joining in once we start. No one wants to be left out when a bounce finally kicks in.

If you want to play a bounce, the best advice I can give us to wait for some positive action to hold. The pattern lately is that the overanxious bounce buyers create some early strength that is used by bears and "stuckholders" as a means to escape long positions. Once we roll over and start making new intraday lows, more sell stops are triggered and the downside momentum builds.

What we have to watch for is a change in the pattern. We need some higher highs, which will force shorts to cover and longs to gain confidence. After we hold in positive territory for a while, then more longs will start to inch in and a bounce can build some steam.

If you do play a bounce, keep stops very tight, and, above all else, treat the move as a bounce and not a bottom. Playing counter-trend moves can make for some good trading, but it drives me crazy when the overanxious bulls treat any little bounce as a major bottom. Don't even think about a bottom until this market has proven itself for more than a few days. The great likelihood is that we have not seen the lows yet and that a bounce is just a way to suck in some new victims to feed the market beast.

The biggest obstacle to a major market turn at this point is that we just aren't going to have much clarity until this fiscal cliff issue is resolved to some degree and that is not going to happen until the deadline nears. In addition, Europe is struggling more and more, and the solutions to the problems are become less and less certain.

We are definitely due for some sort of relief bounce soon but, as we have seen, the market can continue to downtrend much longer than seems reasonable. If you are going to play the bounce game, make sure you manage that risk very tightly, and don't forget to lock in some gains pretty fast if and when you have them.

More money is lost trying to catch a market bottom than anything else, but people will never stop trying to do it. If you maintain the right mind-set about it and use some rigid money management, you can handle it, but stay very cognizant of the danger involved and don't hesitate to take your losses if things go badly.

We have some minor early strength once again, which has not been a good indicator lately, but the anxiety to catch a bounce keeps on growing.

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