It has been a rough week for the market with some of the worst corrective action in months. We can moan and groan about losses but for opportunistic traders this is the sort of market action that eventually leads to the next crop of great trades.
The key is to have the right mindset and a bit part of that is make sure you aren't struggling with too many losing positions. If you have been lax in taking stops or cutting losses, it is never too late to do so. Too often we sit in a poor stock because we feel it is too late to sell. Perhaps that it is late but it is important to take into account the mental cost of holding onto losing positions. When you have a big loser it uses up your mental energy and will prevent you from taking advantage of other opportunities that may develop.
Quite often when I am holding a position that I like longer term but it is acting poorly technically, I will 'sacrifice' some to the market gods. I'll dump some just to appease the market that seems determined to shake me out. That sacrifice will relieve some of the mental pressure and will allow me to start looking for a new entry point rather than just sitting and hoping that the stock doesn't fall further.
The most important element to dealing with poor market action is your mental state. At times I will sell everything I am holding. Clearing the decks has a profound emotional impact and completely changes the way you view the market. Rather than fret about the poor action, you start to embrace it as you can see the new opportunities that are developing.
The big objection to this sort of move is that you will no longer be holding stocks that you are optimistic about longer term. The easy solution to that is to buy them back. Just because you sold something doesn't mean you can't buy it again. Maybe you even have to pay a higher price for it at some point but it can still be well worth it if it improves your mental attitude and helps you deal with short term risk more effectively.
The most powerful tool you have in a poor market is the 'sell' button. People are often afraid to use it because they fear their timing will be dead wrong. It might be but the cost of that mistake can be kept small if you focus on finding new entry points. You'll often find that you can be even more aggressive with your favorite stocks when you are looking for a second setup to develop.
The Approach Used by Big Funds
If you want to approach the market like big fund managers the key phrase is 'basis reduction'. Jim Cramer often employs this method in his Action Alerts PLUS Portfolio. The key is to identify stocks that you like on a fundamental basis. Technical action tends to be secondary to big funds that don't have the flexibility to move in and out of positions quickly.
Once you have identified a name that you believe is a good value then the next step is to keep looking for ways to reduce your cost basis. If you are right about the fundamentals then you should be buying the stock at lower prices any time you can. The theory is that the market is not pricing your stock correctly so it makes sense to add move.
There are two problems with this approach. The first is that there has to be a point where you admit that your fundamental analysis is wrong. You have to cut a loser at some point or it will be an anchor. It is a very tough decision to admit that you are wrong about a core holding like a General Electric (GE) but if you don't admit it you will have some heavy baggage.
The second problem is that many individual investors tend to average down into positions too big and too fast. This is what wipes out more aggressive investors than anything else. They keep adding to a position and it keeps on sinking. When it doesn't bounce they are so heavily long that they panic and sell at the wrong time.
Big funds can be systematic about decreasing their basis in a stock since they have so much capital to work with. They stay well diversified and are not so concentrated that one position will hurt them unduly.
An Incremental Approach
One approach I often use in poor markets is to establish very small positions in stocks that I like on a fundamental basis and then track them carefully. Having a small position on the books keeps me focused and then I can start looking for support levels to develop or for reversals to occur. Rather than just keep adding to a stock as it becomes cheaper, the primary focus is on adding to the stock as the price action starts to improve.
Many traders believe that they should never average down a position. I believe that averaging down is fine IF you have a preexisting play to do so. It is when you emotionally react to price action that you make mistake rather than work a strategy to take advantage of downside volatility.
We never know how deep a correction might go so there is some risk reduction when you focus on buying strength. The stocks may reverse again but the technical levels are much clearly after a bounce rather than before it.
Market corrections should not be a reason for despair. The downside is what gives us great opportunities. If you have the right mindset and a logical methodology you will be well rewarded while others are complaining.