Volatility can be your friend, or undoing

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As you certainly have noticed, the past few weeks have been messy to say the least. We have seen the major stock indices in America get hammered, but the close on Friday was a melt up. The close might have confused some traders, and certainly caught a lot of people on the wrong side. However, the move to the upside is more likely than not limited, even though we could get a nice pop.

The biggest problem in a bear market is that the volatility picks up – in both directions. The ironic thing is that buyers can get massive returns, if they time things correctly. The moves higher can be violent, and with this being the case you need to cut your position size, even when selling. The general rule that I use when we are seeing indices sell off like we have is to trade everything at half the normal size. This is because of the inherent nature of indices and risk assets, shorting is always a bit more dangerous than buying. All one has to do is look at the longer-term picture of stock markets.

Logarithmic chart of S&P500 going back to 1982.

Taking a look at the chart of the S&P 500 above, does this look like something you should spend a lot of time shorting it? The chart above shows why ‘buy and hold’ works for retirement. However, as traders we try to get ‘cute’ with the idea of timing sometimes. While you can make money shorting, and certainly at the moment this is true, the market spends most of its time going higher. So if this is going to be the case, you will be better off risking more to the upside over time. Again, this is not to say that the market doesn’t offer money to the downside, but more often than not, you make most of your bones betting on higher prices.

Take a look at the NASDAQ below. Going all the way back to the mid 1980s, you have made most of your money betting on higher prices.

NASDAQ going back to mid 1980s.

However, far too many people focus on the short-term, not recognizing that the bigger picture is much different. The recent chart of course looks horrible, and honestly – I think we will go lower from here. Having said that, there is only so much pain that the Federal Reserve will allow. While they are under a lot of pressure politically to raise rates, the Fed wont allow the markets to get out of hand. Wall Street knows this, as the yield curve suggests that the markets think there are a few rates hikes coming, but are already trying to price in a reversal shortly afterwards. In other words, they will try to front run the Fed and push prices higher.

A closer look at the last few months in NASDAQ trading.

In the end, do what you want. The best way to protect the trading account is to cut size, or simply sit on the sidelines until you have clarity. Experience goes a long way, but there are far too many random possibilities in a market like we have at the moment to completely mitigate the risks.

Trade well, trade safely.


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