Warnings about how the current market action is unsustainable have been growing louder every day. We keep hearing that a day of reckoning is coming and that the collapse of the stock market will be epic when it occurs. There is a long list of compelling and logical negative arguments.
The nervous bears will eventually be proven correct but no one knows how much longer this market can continue to run. The prudent action would appear to be to start preparing for the disaster that awaits. Raise cash levels, sell down positions, and maybe even try some index shorts.
However, as famed investor Peter Lynch once said: "Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves".
The current market has been a great illustration of this. There has been a huge amount of underperformance since the March lows by those that have been anticipating another market drop. Not only has there been huge opportunity lost due to missing out on some great trades but there are actual losses caused by trying to actively short indices that refuse to go down.
What many market players fail to appreciate is that aggressive short-term trading with a bullish bias is not inconsistent with caution and defense if you approach it correctly. You can still trade strong stocks and remain quite cautious. The key is to adjust your approach to managing risk more carefully while staying extremely aware of the need to move quickly when conditions change.
There are four areas that you will need to focus on if you want to aggressively trade while maintaining a high level of caution.
- Time frame. Time frame is the most important factor that you can control. The shorter your time the less risk of being caught in a sudden market reverse. However, the shorter your time frame, the more difficult it is to find trades that work. It is extremely easy to be shaken out of a 'good' stock if you overreact to normal volatility. If you are a pure day trader you will avoid the elevated risk of holding overnight but, generally, the big gains tend to occur overnight and you will most some of the best trades when stocks gap-up the next morning. The best way to deal with the challenges of the time frame issue are picking the right stocks and using disciplined money management.
- Pick the right sectors and stocks. Stocks do not all move in tandem. At any given time there is going to be some very strong areas of momentum and some laggards. If you are staying in the hot sectors and stocks, you are going to be much safer than if you are trying to catch moves in stocks that do not have favorable charts or positive momentum
Recently market strength has been in the technology sector and some hot sectors like Electric Vehicles and Special Purpose Acquisition Companies. If you have stuck with those groups there has been very strong upside potential but there is also a high level of volatility which requires astute trading strategy.
- Money management. The most important thing you can do as far as money management is to stay intently focused on keeping your accounts as close to highs as possible. The best indicator of a change in the market is your profit-and-loss statement. When you start losing money that is the signal to get out and raise cash. Where most aggressive traders go wrong is that they refuse to acknowledge a change in market conditions. They stick with what had been working and let losses grow while they sit and hope for another run to bail them out.
In a market like we have now with some grossly overbought conditions, it is extremely important to be aggressive at cutting positions at the first sign of a problem. My methodology is to take partial profits into strength when I can and then look for another setup in the same stock to trade.
- The Right Mindset. What will determine your success more than anything is the right mindset. If you do not have an optimistic and positive view of your ability to navigate a tricky market, then it is very likely you will not do a very good job of doing so. I start every day feeling confident that I will be able to find some new opportunities and, more often than not, I am right.
If you live in constant fear that the market is going to suddenly collapse then you will not be able to trade effectively. While it is very helpful to understand the bearish arguments, it is important to not embrace them too tightly if the price action is saying something different.
Trading environments like we have now don't last forever but if you take advantage of them while they exist you can build a huge cushion of gains that will protect you from more difficult market environments. Too many market players are so worried about the market suddenly fall apart that they miss out on very sizable gains while they wait.
Aggressive trading and strong defense are not incompatible. The key is to develop strategies and thinking that allow you to move quickly and adapt as conditions shift.