This commentary originally appeared on Real Money Pro on Feb. 9. Click here to learn about this dynamic market information service for active traders.
Having survived far too many nasty bear cycles, I have compiled a set of rules you may want to use for your own trading survival, if not make a few bucks while stuff is hitting the fan at turbo speed. But before getting to the list, know that in order to survive the nasty bear (if you're a bull cycle trader/investor) you have to do your own decision making. Navigating this path involves surviving first, and then being in the game the next time the bull grows a new pair of horns.
For historical, if not poetic proof consider the wisdom of Rudyard Kipling and then Friedrich Nietzsche. Kipling's words of wisdom about "keeping your head when all about you are losing theirs..." implies that if we can stay calm when the other 95% are freaking out we can then see what they cannot. Your reward for doing so is found in the fact that every bear cycle since you have been alive has been overcome by the next bull cycle. So, even my dog knows that if he can survive this stock market storm he is in great shape to play the next bull market. As for Nietzsche's sagacious logic, that ditty goes: "What does not kill us, makes us stronger."
Combine these two genii and what you get is this collective wisdom: If you can stay cool under fire, as only the stock market can test you, then you will only be the better and the wiser for having done so. And you might be around to buy at the next stock market bottom!
All bear cycles end at some price and time. While each bear cycle is unique unto itself the common threads that signal a bottom tend to be the same. However, I do not recommend that you attempt to predict when and at what price that bottom might be as you might have to keep predicting that same event more than once. That fruitless exercise can get expensive.But know that it won't get expensive for the perma-bear as they don't really believe their own garbage. The logical proof of that is this: If they did take their own loudly broadcasted trades they would have lost far more capital over the bull cycle years than they could to emotionally, if not physically survive.
Better to let the market show you that it has suffered the last seller, and has begun to lift in spite of more bad news continuing to roll in. It's the reaction to that seemingly endless bad news that signals a bottom. Thus, watch for reactions to bad news being a move up (for the market), even a sharp one, on the public announcement of that expected bad news. This sharp type of reversal action (up!) is spike-like on a chart, the proverbial moon-shot variety that bull-side traders love to experience when long at just the right time and price.
That other type of bottom, not the spike type that I just mentioned, is the flounder bottom. I use the word "flounder" as the market condition is literally floundering around, listless and directionless. "Flounder" also implies the actual fish, which is flat and feeds and lives at the bottom of the ocean.
Either one of these two bottoms is not easy to see, but can be felt. And the best way that I know to feel any position is to have it in your gut. But don't expect any help from the financial media, as they flourish when the stock market is suffering daily "train wrecks." In addition, and in keeping with their inaccuracy about stock market bottoms, practically all of them have never traded for a living. Why would anyone take advice about doing anything from those who have never walked the walk. It boggles the mind (mine), yet this dynamic goes on every day.
Of the vast majority who invest in stocks, very few of them ever hedge their portfolios with put options or options on ETFs, which offer downside insurance via their shares or on those ETFs. Instead, they may own precious metals, which over time have not proven to be effective bear market hedges. All I can say is that ignorance of these protections, or lack of desire to employ them, is not wise as by not using them that quip from Nietzsche will most likely come into play.
For those who do hedge their long positions, they have an excellent chance to keep their heads and gain strength having made it through the current bear cycle storm.
The best time to buy such protection is when that "insurance" is being offered at what experienced options traders know to be "wholesale" prices. This wholesale pricing is measured by the option's volatility "cost." For me, that wholesale cost begins around the 12 level, a value that for the past 4+ years has been hit more than enough times to have woken up those who understand what I'm referring to here. For reference, that cost is currently more than double that 12 level, as its best measure, the VIX, closed trading yesterday at 26.
So here are my rules for surviving a bear cycle, measured as one lasting at least four or more quarters, or 52 weeks:
1. Every bear cycle is preceded by a bull cycle which had the VIX drop down to the 12 or lower level. Ergo, buy downside protection at that time and price for as far in time to expiry as the market offers.
2. At the zenith of any bull cycle, intermediate-term sentiment indicators, such as the 10-day average of the Arms Index and/or the AAII Weekly Sentiment Survey, will have signaled that the Overbought stage has been triggered. That's your own bell/signal to buy downside protection (or, of course, sell long positions to raise cash).
3. No bear cycle is the same, nor can the bottom for it be predetermined. All who attempt to predict such are full of themselves, if not excellent indicators in their own right as to not to listen to them.
4. ETF stands for Exchange Traded Funds. These funds are trading vehicles, just as their acronym implies. They are not called EIFs, or Exchange Invested Funds, for an obvious reason, that being that any ETF is traded on a daily basis and thus can be quite volatile. Therefore, do hedge long ETF positions with long/married puts or suffer the slings and arrows of the high-frequency traders.
5. Do rely somewhat on charts during a bear cycle but know that bottoms are secured only when the fundamentals begin to turn up for the better.
6. Options volatilities such as the VIX, the VXX and those of individual stocks will begin to recede as the bottom is quietly formed. Thus, watch the "vols" like a hungry hawk watches each move of its potential morning meal.
7. If oversold sentiment readings begin to form, consider owning call options (or bull spreads) on stocks that clearly show that their relative strength is on the rise. You will see that strength grow as these stocks hold their price level when the vast majority of stocks are getting whacked. Then on the quick, sharp upside reversals they turn up very quickly to trading up on the day. However, be quick to flip these winners once that upside momentum begins to falter, and don't wait too long to take that quick long-side trade gain. Doing so will increase your confidence and grow your capital account.
8. If in doubt, stay out! No one is forced to own or buy anything, especially a trader.
9. Keep track of the changes in the bi-weekly compilation of the NYSE Short Interest totals and especially its percentage changes. Be alert for this total number of shorts to recede for at least two consecutive readings (four weeks' total) as the shorts are always the first to buy! The reason for that is because they have the most to lose by not buying. And take note (and never forget) that there is not one reason why people buy stocks, there are two. The first reason is the obvious one, the greed factor that drives the newly long bullish buyer to part with his or her capital in exchange for shares of stock. Reason No. 2 is that short seller who has to buy stock to cover that profitable short sale, or possibly risk seeing that nice profit disappear. Short sellers who make consistent profits are far more keen to any bottom forming because they have the most to gain and lose by not being so keen. I know this because the vast majority of my trading profits over the years were made from the short side in a relative short period of each short's holding period.
10. This is the big one: Do not commit to any intermediate- to long-term bullish positions until your sentiment indicators show that both the short-term and especially the intermediate-term sentiment is in a condition of being deeply Oversold! The old trader joke about not following this dictum is this: "The pioneers are the ones with the arrows in their backs." Far wiser to let the other guys be the pioneers as the next bull cycle will be much like all the previous ones -- and tend to last years and not days or weeks.
Whatever you do, do not beat yourself up. We have all done things that shouldn't have been done. You are not the first in that long line of sufferers and you certainly will not be the last. Instead, keep your head in the game, your chin up, and meet each day as a new one,which is exactly what professional traders do every day!