The Hazard of Chasing Trends
Stockscores Foundation for the week ending March 4, 2019
In this week's issue:
In This Week’s Issue:
- Stockscores’ Market Minutes Video – Trading Process is Everything
- Stockscores Trader Training – The Hazard of Chasing Trends
- Stock Features of the Week – Correction Protection
Stockscores Market Minutes – Trading Process is Everything
Most stock traders focus on the entry signal but without good process, the execution of a good strategy will fail. This week, I discuss the different components of the trading process. Plus, my weekly market analysis, a search for stocks with the Stockscores Market Scan and then the trade of the week on BPTH.
Click here to watch https://youtu.be/zz1zvkt242M
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Commentary of the Week – The Hazard of Chasing Trends
How do you feel when the market or a stock is going up quickly? If you are normal, you will feel some emotion, either that you are missing out on a great opportunity or that you should panic if you are on the wrong side of the move. This presents a problem because savvy traders and their computers are out to take advantage of that emotional response.
Consider today. It started with a strong gap up at the open, meaning it opened quite a bit higher than the market closed on Friday. It also broke out through four and a half month highs, another reason for investors to be excited. This sort of a price move makes investors want to buy because they fear that not buying will leave them behind a market that will continue to surge higher.
During the premarket comments I made to my Active Live subscribers, I advised that buying stocks at the open was not a good idea. If anything, short selling stocks (trading in anticipation of them going down) was the best course. I think it is important to understand why I made that recommendation.
Stocks were up on Friday and the open today made the market very overbought. An overbought market is one where price has run up too quickly, meaning that many of the buyers are acting out of emotion rather than a rational assessment of company value. I measure how overbought, or oversold, a market is by considering how many standard deviations price is away from an average. For those that skipped their high school statistics class, this is simply a measure of how far away price is from its average of recent prices. The farther above, the more overbought. This morning’s open was exceptionally overbought.
One common, and pretty simple, strategy of those who program computers to trade the market is to sell an overbought market and buy an oversold market. This strategy is called Mean Reversion, trading with the expectation that prices will work their way back to the average.
While the market opened today very overbought on an intraday chart, it has since sold off sharply and is actually now very oversold. That means the computers are going to come in and start buying the market with the expectation that prices will move up over the next few hours and work their way back to the average.
A market can be overbought or oversold on a short term time frame but rationally priced on a longer term time frame. It is important to consider the emotion of the market relative to the time frame you are trading. If you are a long term investor, you should be considering the weekly time frame and not the 13 minute time frame that I am using for my day trades.
You may have heard the expression, “The trend is your friend” or “Always trade with the trend”. This is again in reference to the average of prices over time. If that average is rising, then the trend is up, and we should focus on buying rather than selling.
However, even in a market that is trending up, there are times when you should not be a buyer. That comes when the market has gone up too quickly, has run up and away from its trend line and is attracting emotional investors who are buying out of their fear of missing out. This is a hazardous time to chase the trend.
If you want to trade with the trend, wait for the pull backs to the upward trend line. This is applicable to buying individual stocks but also for analyzing the overall market. My weekly Market Minutes video that I put on Youtube will always consider the trend and where price is relative to the trend. So, if you want my help, watch that video each week, especially since it is totally free to do so.
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As I write this, the market has made a Bearish signal that indicates more weakness may be ahead in the coming weeks. After a great rally from the Dec 24 low, stocks have been unable to break through the October and November highs. The market gapped up on the open this morning through that important barrier but sold off almost immediately, making what is called a Bearish Engulfing Candle. Assuming the market closes near the low of the day, this is a reversal signal that will probably lead to further weakness.
How do you protect against a market correction? This is easier than ever with the many inverse and volatility related ETFs that exist. Below are three to consider. These should only be considered by savvy traders who can watch intraday charts to pick entry points as they can be quite volatile through a market correction. Good risk management is essential:
VXXB is the new version of the VXX and reflects the implied volatility of the S&P 500 Futures contracts. It tends to go up when the overall market goes down in a sharp fashion. During the correction that started Oct 4 of 2018, it moved from under $30 to about $50 over three months.
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QID is a leveraged ETF on the Nasdaq 100 index, representing mostly large technology stocks. It goes up 2 times as fast as the market goes down on a daily basis with the fund getting rebalanced each day to maintain this leverage. If the Nasdaq market sells off significantly, this will go up.
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SDS is also a leveraged ETF but it is based on the S&P500, a broader group of stocks than the tech focused QID. It also is designed to move -2 times the S&P 500 on a daily basis.
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