Our exposure to stocks relies on two simple elements that feed on each other. In a stock market correction, the market looks weak and swing trade setups are either hard to find or fail quickly. When more swing trades set up and succeed, along with evidence of a reversal in the general stock market, it can suggest the stock market correction is over. But at these critical turns it’s wise to tread cautiously. Only increase exposure as your swing trades continue to work.
Avoiding The Recent Stock Market Correction
The last few months offer a prime example. On Sept. 26, IBD’s SwingTrader had seven stocks on its list (1). Sell rules, especially taking profits on the way up, started pushing us out of most stocks. The setups also dried up, so we didn’t have fresh stocks replacing them. At the same time, the stock market’s progress slowed. Two days without progress led to a bearish reversal (2).
Things worsened from there. On Oct. 4 we only had one stock, Netflix (NFLX), and it left early that day (3). This “vertical violation” of the 50-day moving average often warns of a stock market correction. This isn’t the first stock market correction to show this action. Most recently, February and March of this year and January 2016 looked similar. (Links to those examples are below.)
With our exposure at zero, we avoided a lot of turmoil. Swing trade setups remained sparse, and the stock market correction suggested a low probability for successful swing trades. A few bullish reversals caught our attention on the way down. But they often didn’t follow-through in a meaningful way and the stock market correction continued. Oct. 8 is a good example of that (4). Also, few swing trade reversals looked proper at these attempted turns.
One rally that did look promising got us to venture back in lightly. As the stock market recovered back above its 200-day moving average on Oct. 16, we put on a test trade (5). It was an earnings option play where we had a good setup in Centene (CNC), but earnings were looming. We did a half-position trade to limit our risk even more. If the stock market held and the stock soared after earnings, we could participate, and even add to our position. If the stock tanked or the stock market correction continued, our maximum risk was 1.7% because of the protection from the option.
In this swing trade, Centene gapped down after earnings and the stock market correction continued. The small loss in a single half-position trade was insignificant compared to the stock market drop during the same time. But we still searched.
Is The Stock Market Correction Over?
The stock market seemed to put in another bottom and after three days of a rally we started to put watchlist stocks on our list (6). The idea is to stay engaged so that you’re ready when the stock market correction ends. Some of the best swing trades come early in the trend change. A couple of days later we triggered watchlist stock Ciena (CIEN) (7). The stock market held above its most recent gap and more swing trades presented themselves.
A few days later and the stock market produced a follow-through day (8). This is an important signal that the stock market direction is now positive. So what does that mean for us now?
While this does signal a potential bottom, there is still reason for caution. Not all follow-through days work. Rather than plunge all your money in at once, it’s better to put a few trades on and only enter more swing trades if you are finding success. An improving batting average is an important indicator of the stock market’s health.
We also have that “vertical violation” to contend with. Historically, the first follow-through day doesn’t always end the stock market correction. If the rally itself doesn’t fail, there is often sideways action to contend with. Swing trading can often exert an advantage here. Taking profits quickly can help you get the most out of a short-lived rally. If it fails you won’t find swing trades to replace your sold stocks. If you do see more swing trades set up, you can continue to participate if the rally continues.
More details on short-term market action and swing trade ideas are accessible to subscribers and trialists to SwingTrader. Free trials are available.
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