Market corrections are inevitable and present the most significant challenge that traders and investors will face. Thousands of new traders that are enjoying great success in a market uptrend will quickly discover that trading is not that simple. They will hold to positions and even add to them with the belief that the market will recover and bail them out once again, but eventually comes a day when the market doesn't cooperate and they will sell in dismay as they can no longer stand the pain.
If you use a trend following approach to the market, as I do, there will come a time when the action reverses, and you suffer losses. If you have stuck with the trend as long as possible, then it is inevitable that you will give back some gains at some point.
I believe this approach is superior to continually trying to anticipate a market top and avoid even a penny of loss. In the current market, there have been anticipatory bears sitting on the sidelines for months. While they have avoided losses, they haven't made any money instead.
My experience is that if you forego the anticipatory market timing in a strong market and pile up the gains, then you will still be far ahead of the game even if you incur losses at a market turn. The key, of course, is to make sure that you don't give back too much. My goal is to try to keep my accounts as close to highs as possible so that I don't have to go through the unproductive work of making up losses, but there will always be times when your accounts pullback as the trend shifts.
Here are some key issues to consider when navigating a market correction:
1. Accept the fact that the market is cyclical. Corrections are not only inevitable but healthy. Markets need to reset periodically to set the stage for the next up-cycle. The goal of the market beast is to make that difficult for us in various ways, so we will have to be very strategic to stay a step ahead.
2. The nature of trading is that gains tend to build slowly over weeks and months while losses occur very abruptly in a matter of days. There is an old saying that the market is an escalator up and an elevator down. If I were to chart the returns in my accounts, I would have long uptrends and some very sudden drops. That is how it always happens, and it causes quite a bit of discouragement and disappointment for traders that aren't used to it or have unrealistic expectations about the market.
3. The goal during a correction is to stem losses as quickly as possible and raise cash levels to ensure a high level of flexibility. The biggest problem that traders face is that they tend to freeze. There is a natural resistance to selling into a decline. We don't want to 'guarantee' a loss closing a position, and we bought it in the first place because we were convinced it was a good stock.
The best move you can make is to break the inertia. Sell something even if you think it may be a 'bad' sale just so that you feel more comfortable with the process of hitting the 'sell' button. It is imperative to remind yourself that you can always reenter a stock. Maybe you can buy it lower, or perhaps you will repurchase it at a higher price. It doesn't matter much. The critical issue is that you reduced your risk. It is just a form of insurance to sell and then rebuy a stock.
4. Many market players feel trapped when they failed to sell a stock, and now it is down big. The best move to deal with this is to forget your entry point. Forget the fact that you have a loss and mark to market. Treat the stock as if you just bought it 10 minutes ago and then evaluate how you would handle the trade. Where would you set a stop? Where would you sell it for a gain? How would you handle the trade if you just entered it? When you look at the stock in that way, you let go of all the emotional baggage you are carrying and make better strategic decisions.
5. The great thing about market corrections is that they lead to some very good entry points. Buying as a correction plays out is much different than buying during a normal uptrend. The most important factor to keep in mind is that markets tend to bottom much faster than they top out. The biggest upside moves in the market occur in the context of the worst bear markets. The bounces are very abrupt.
6. At the bottom, the 'good' charts won't look like a typical 'good' chart. It is important to look for support levels that can serve as a natural stop-out point. The best entries tend to come when lows are retested and hold, but it seldom is that easy.
7. Have a shopping list ready but be ready to add some new names that show good relative outperformance. Quite often, it isn't the stocks you rode down that will make up your losses - it is something new, but it is easy to become emotionally involved with a stock that you have held through a poor period. Don't be sentimental. Demand that stocks perform before you award them some of your precious capital.
8. V-shaped moves have become the norm in recent years, and that means that you have to be quick to put capital to work once a recovery starts. This is a significant change in market dynamics, but the quickness of the rallies can not be denied.
9. Stock pickers tend to excel in market bounces because, during corrections, stocks are all sold together. The good are dumped along with the bad. When the bottom does form, there will be many 'good' stocks that have been unfairly punished. Therein lies the great opportunities.
The most important thing you can do during a market correction is maintain a positive mindset. That doesn't mean optimism that the market will go straight up. It means optimism that you will find effective ways to navigate the action that ultimately will lead to more profits.