5 Essential Rules for Trading Market Pullbacks

market pullbacks

Market pullbacks are inevitable. No matter what you trade, nothing goes straight up forever without pullbacks or crashes. This week have seen a large pullback in the US stock market, and I see people panicking and making the same mistakes every time. 

When you have the right rules and training, days during a market pullback and high volatility can be some of your biggest winning days. Instead of panicking like 90% of investors, you can use these 5 rules to put yourself ahead of the curb:

1. Let the Bottom Pick Itself

Picking tops and bottoms is a fool’s game. Jesse Livermore said it best: “The first ⅛ and the last ⅛ are the most expensive”. Even with support and resistance and other indicators, strong trends will usually last longer than everyone anticipated. 

Trying to pick the bottom can lead to death by 1000 cuts. Even if you taking small losses, you can still, end up having big red days by taking a bunch of small losses, and get eaten alive by commissions. Instead, wait for confirmation that the bottom is in, and join the uptrend. Wait for series of higher highs and higher lows, and a remount of the major moving averages. 

2. Oversold Can Become More Oversold

“But it’s RSI was 15!” Indicators often will go out the window. Remember: “Markets can stay irrational longer than you can stay solvent.” We are seeing that in the oil sector currently, and longs are getting crushed trying to catch a falling knife. There is no rule that a market has to reverse when it starts going down. Don’t try to be the hero and pick the bottom. 

3. Use Margin With Caution During Crashes

My rule of thumb for margin: “Use it to add to winners, NEVER for losers.” Margin can be your best friend, our your worst enemy. In times of high volatility, it needs to be used carefully. 

All stocks are trading outside of their average range. This means when you get stubborn, you can take even bigger losses. And when you use margin on losing trades, these losses can become even bigger, and lead to potential account blow-ups.  

4. Don’t Chase Strength

New traders often confuse rallies with “the bottom is in”. Markets don’t move straight up or straight down. Some of the biggest days in the market actually occur during market pullbacks and bear markets. But it doesn’t mean the bottom is in. These are often just dead cat bounces or short covering. The market rallying temporarily is NOT a buy signal. You need to have a series of higher highs and higher lows, not just one move to the upside.

5. Use Wider Stops

During major market pullbacks like we are seeing now, all stocks and ETF’s are trading above their normal trading range, especially high beta names. Facebook’s ATR (average true range) is 4.83. On days like yesterday, it will move 8-10 points. Whether you are taking a short trade or counter-trend scalp, you need to use wider stops so you don’t get taken out of a winning trade prematurely. 

This means on the trades you take, you have to use wider stops to account for the larger range. Using a 1 point stop trading it during uptrending market conditions might work. But that would be way too tight on days like today. You will get stopped out prematurely, and miss the move your anticipating. Use wider stops one day of high volatility (but be sure to obey them!).’

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