Tips and tricks for trading in a downtrend market

Younger investors that joined the market in the past few years are facing increased difficulties in today’s market. The recent sustained bull market has made lots of investors believe that markets can only go up and that every dip in price is a great buying opportunity. Unfortunately, this is one of the biggest misconceptions that can cost traders their entire portfolio. Markets do move in an uptrend over the long term, but there are several periods of pullbacks and even outright bear markets. In this article we will highlight several tips and tricks for traders who are looking to continue trading and making money when the overall market takes a turn to the downside.

2022 has started on the wrong foot. As soon as $AAPL reached a market cap of $3 trillion, both the $SPY and $QQQ made a top. What followed until now was an accelerated downtrend with plenty of opportunities to get out of harm’s way and even profit. With the indices still down more than 10% from the highs, a lot of investors are asking themselves whether the recent lows will be the lows of the year. This article will argue that irrespective of this, traders need to prepare for whatever the market throws at them and make the most out of it. Bear markets are great opportunities to create wealth, and investors need to embrace the volatility surrounding such periods and profit from it.

  1. Spot trend reversal ahead of time

The first difficult aspect of a downtrend is to be able to spot it before the selling accelerates. If investors spot in advance a trend reversal, they can correctly adjust their portfolios and keep their hard earned capital. Spotting trend reversals looks easy with hindsight, but there are several important conditions that if met, should allow one plenty of time to adapt. In our recent case, we had 2 important warning signs that helped us switch positions. From a macro perspective, the rampant inflation is a key headwind that directly influences the market. With higher than expected inflation stemming from the accommodating policies of the FED during the pandemic, it became clear that interest rate hikes will be the only solution to address it. As early as November, the FED starting hinting that in 2022 several rate hikes will take place which would make it less accommodating. As the FED will stop its purchases and begin increasing the interest rate, stocks will become less appealing to investors. In particular high growth stocks, with a high Price/Earnings ratio will be hit the hardest. This narrative was corroborated also from a technical analysis perspective. In the following example we will look at the S&P chart, exemplified through the $SPY ETF.

$SPY chart

The S&P posted its all time high on January 4th. The actual candle on this day was a reversal candle, which was the first sign that the bulls are losing momentum. A reversal candle occurs when the price of the stock/ETF opens below the previous day’s high, goes above it, only to retreat and close well below it. This was the case on January 4th. In the next few sessions, we had a small pullback to the moving averages and made a lower high on Jan 13th. A lower high is once again indicative of a loss of momentum. The following day we had the first important confirmation with an engulfing red candle that broke below all key exponential moving averages (red, black and purple lines on chart). If traders, spotted the reversal and reduced risk, and got out of the way on the confirmation candle following a lower high, they would have saved themselves at least 12% downside. For more details on the use of moving averages, please go back to out E-book.

2. Day trade instead of portfolio approach

Once the upper trend brakes, investors need to quickly adapt to a new trading strategy. During uptrends, when the price of the asset is continuously above the 8&21EMA, investors need to be in a portfolio approach, holding between 10-30 stocks in their portfolio. In such instances, most dips are good buying opportunities, while extensions are good areas to sell into strength. Once the trend reverses, the exact opposite happens. Once traders recognize the beginning of a downtrend, they need to abandon the portfolio approach, exit all their longs and wait until the dust settles. This does not mean that one has to stop trading, but rather to focus his trading skills on day trading rather than keeping a longer term portfolio. Every day, investors need to come in flat and look for opportunities to either go long or short depending on recent support and resistance levels. In such a manner, investors avoid the risk of being in harm’s way, while at the same time can still make some money by trading pre-defined ranges.

3. Use previous support areas as resistance

In uptrends, support areas are defined by the exponential moving averages. In theory, dips to the 8 and 21 EMA are good buying opportunities. During downtrends, these exponential moving averages become resistance areas. As you can see from the chart above, the 8,21 and 50EMA have become important resistance areas in the following 2 months. As this becomes clear for traders, they can engage into long positions for day trades with clear profit taking strategies around these important resistance levels.

4. Look for oversold areas

One of the most lucrative aspects of bear markets are the impressive oversold rallies that occur from extreme areas. We had 2 such examples in the past 2 months. On such days, traders need to be able to allocate most of their portfolio in order to take advantage of such aggressive moves. Once the price reaches such oversold areas, which can be measured using Fibonacci levels, RSI or Osciallators, the risk reward ratio is once again favorable for being long. During the first oversold bounce, we had a rally of almost 40 points in the $SPY over a period of just 8 sessions. The sheer magnitude of this rally should have made investors enough money for a year’s worth of trading if approached correctly. As mentioned earlier, the moving averages during downtrends remain important resistance areas, and investors should have taken profits along the way as price was rejected twice exactly at the 50 SMA (purple line on chart). In addition, a double top was formed around $458 which was indicative that the current sell-off was not yet finished. After another impressive sell-off accelerated by events in Ukraine, traders had a great opportunity at the end of February for a monster oversold rally. In this instance, the moment war officially broke out on Thursday (24th of February), indices were down 3% in pre-market. In most cases, ‘invasion’ days are great buying opportunities, as the market already prices in al the negative headlines. The rally that followed was relatively easy to participate in given the fact that low of the day was put in the first minute candle. Buying vs. this low allowed investors to make 20 points in just 4 sessions. These 2 oversold bounces were great opportunities to create wealth, and in the second instance, our portfolio was up 30% in just 2 sessions, as we went all-in using both stock and options. The main idea is that oversold areas are great buying opportunities with pre-defined risk, and one can profit from them in a big way.

$SPY chart

5. Short into resistance

During downtrends, another lucrative strategy is to initiate short position after the price bounces to resistance areas. This strategy is similar to the one used during uptrends, when investors add to their positions once the 8&21EMA are re-tested. Since traders recognized a downtrend, most bounces so far in the past 2 months were great short opportunities. By shorting the $SPY at the 50EMA around $458, investors had the opportunity to net in 40 points by Thursday’s big gap down. Our argument is that during downtrends, investors need to have the adaptability to take advantage of the increased volatility and make money both long or short depending on the current situation.

$SPY chart

6. Cash is a position

During downtrends, investors and traders alike need to acknowledge that cash is also a viable position. By holding on to cash, instead of being invested, one has the necessary flexibility to adapt to whatever the market throws at him. As a result, one has the required mental strength to be able to wake up one day when the indices are down 3% and see these situations as great buying opportunities. Similarly, cash allows investors to feel safe during these periods. If they do not have the necessary time to day trade, keeping cash instead of a portfolio approach is the correct strategy until the dust settles.

We hope these strategies will allow you to become a better trader. Keep in mind that the markets never go only up, but that there are periods when we have pullbacks and even bear markets. This does not mean that we stop trading, but rather that we change our approach. Our technique is suitable to any market environment and if you would like to find out more, please do not hesitate to get in touch:

[email protected]

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