Identifying high probability trades at the right time.
The market 'bottoming out' is a process that takes its own time. When you are trading stocks, you need to be aware of the bottoming-out process to better manage and understand your trading strategy.
I personally use numerous indicators within my strategy to stay on the right side of trend and momentum, using Moving Averages and the MACD indicator in particular.
When it comes to the bigger picture however, knowing where we are in a market cycle also helps us understand past and future performance, identifying a market bottom is part of that process.
See my recent video on improving the probability of identifying a market bottom using an RSI divergence technique.
Should you bottom-fish
One of the most tempting lures for new traders in a falling market is to buy stocks that have corrected significantly from the top. Some traders try to get some quick bucks from a bounce in such stocks while some try to hit a jackpot, thinking that the price will reach its older highs.
Unless you have a mechanism to identify and trade the bottoms, you must refrain from randomly taking bottom-fishing bets. When a high-flying stock from a bull market crashes, it takes time to reach its earlier glory. Also, if the fundamentals deteriorate post the fall, some of these stocks go down to become penny stocks.
When you are bottom fishing, your best bets may be defensive stocks. Stocks that are in sectors like healthcare where consumption generally comes back quickly as soon as the weight of the market is lifted. The returns on such bets are also not high, but traders take these bets for the safety they offer.
Trading reversals vs strength
Some traders swear by buying low and selling high, while some love momentum and prefer to buy high and sell higher.
As indicated earlier, a thoughtless 'buying the dip' isn’t the best strategy, and if you are trading reversals, you must have some rules and criteria that a stock must fulfil to qualify as a trade-on-reversal candidate.
I'm sure most of you have heard the phrase 'catching a falling knife', unless you have a thorough understanding or strategy for 'buying the dip', it will be much like trying to catch a falling knife.
Most reversal traders don’t look to buy on the absolute bottom, but allow the stock time to consolidate. Prior to the bottom, the stock is first sold heavily by panic sellers. It then languishes near the bottom for some time to find new takers. Depending on the underlying fundamentals, the cooling-off period may take a few weeks to months. If it’s taking longer, the stock is probably a value-investing candidate and not a reversal trade candidate. This is why positive momentum is so important to a trader.
This video on market theory helps to understand how the market transitions to and from a bottom through the psychology of all participants.
An investor can spend as much time as required to play the reversal, but a trader must always look to enter at the best spots that allow for speedier for returns. This is also why the technical setup of every trade is of utmost importance when trading reversals.
Then there are other traders, who look for strength in stocks to trade. They look at the stocks that are near their new highs, but only when the markets are languishing near the bottom. Such stocks tend to be the candidates that will lead the next bull market when it starts. Traders who are able to identify such stocks early make a killing when the market finally turns.
Time for the market to bottom.
Market bottoms take varying amounts of time. In the fall of 1929 markets took years to bottom and stock returns were lacklustre for a long time, while the fall of 2008 and 2020 made a quick bottom and reversed equally as quick.
The time taken depends a lot on the liquidity support the market is getting. If there is ample money lying around, the market will quickly bottom and reverse. If the money is expensive and scarce, it will take its time before momentum returns to the market.
For past bear market declines, including duration and % falls, the below video may be of interest.
Focus on individual stocks
If you have a process that produces a shortlist of tradeable stocks, as I do each week, the process then becomes simple. If your watchlist is getting bigger and there are many potential trading candidates, that could be a signal that the market is becoming more conducive for trading, regardless if the indices are showing signs of bottoming or not.
You also need to ensure that you don’t relax your screening criteria when the markets don’t throw up opportunities for a long time. Many traders don’t like to sit and wait for opportunities and tweak the trade eligibility standards based on the short-term thing that seems to be working. It’s always a bad idea to deviate from your edge for short-term gains and traders must refrain from doing so.
How can news be damaging?
The best traders don’t consume too much economic or business news while trading, as the news has the propensity to cloud the trader’s judgment. Especially, at the market bottom, bad news gets too much screen time and results in fearmongering amongst traders.
It will be best for you to focus on data – your screeners, watchlist, and individual stock setups than to be glued to the news. The data will always lead you in the right direction and present the best of trading opportunities even when the news is all doom.
Markets are forward-looking and current news will have been factored in much earlier in the price. At any time, the market will be looking forward to conditions getting better or worse and will react accordingly. Therefore, you will be better off thinking about what the market is trying to factor in rather than being in disbelief if the market actions aren’t in sync with the current news.
The final word
The bottoms are very interesting times in a trader’s career. The biggest money is made by traders when the market comes out of a bottom and a new bull market starts.
Trading during the bottoming process is a skill that takes time to develop. You have to live through a couple of such bottoms to understand the exact conditions that precede the next rally.
Once you have understood the process well, your trading will see a significant improvement not only in terms of making huge returns when the market rallies but also in limiting the drawdown during the bottoming process.
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