Whenever the days turn red, traders begin to think the worst. Instead of joining the crowd, let’s instill some common sense and rules so that next time your stock takes a hit you’ll have a better understanding of knowing what’s really going on.
First and foremost, we need to establish some definitions. The market uses closing prices for these numbers, which means the daily close. This is important as using the highest high or lowest low may get you there quicker, but it doesn’t mean the market agrees.
Pullbacks: Any retracement in the market or equity which is less than 10%. This can happen any time for any reason. Typically, if it’s less than 3%, it shouldn’t even be on your radar. Knowing when to ignore the noise is an excellent thing to do.
Correction: Any retracement in the market or equity which is greater than or equal to 10%. These are steeper corrections that on average happen about once per year in the general market. If you’re trading a high beta stock (highly volatile) this may be happening weekly. As a rule of thumb, expect this in the market on average once a year.
Note: In 2017 the S&P 500 never experienced a correction. Average means just that. The past is there to base assumptions on but never there to concrete the results.
Opposite Trend: Any retracement in the market or equity which is greater than 20%. Typically, there is also a time rule on here of at least 2 months. This keeps gaps based on news/earnings that may correct themselves over the short term from being classified back and forth. There should be little whip saw in terms here from a bullish to a bearish trend.
Let's Look at the Past to Learn for the Future
This is a Weekly Chart of the SPY from ’08 to ’12. If you are constantly trading by your own rules, then this may be of no value to you. However, if you prefer to go a more mainstream route when considering trend definitions, then study this chart. Take it all in. Whether you traded during this time or only learned about it afterward, the definitions of trends can help you go along way.
The Red Box is when the bullish trend turns bearish.
Remember, it takes a 20% retracement from the highest or lowest close to change the direction of the trend.
The blue boxes are all considered corrections. These are all areas that retraced greater than 10% but did not reach a 20% move.
Notice the first correction technically happens before the bearish trend officially begins. Had you tweaked the numbers to highest high/lowest low you would have reached 20% and immediately gone into a correction. Had you instead used the highest close argument you would have stayed away from looking short until the red box closes and would have immediately produced a winning short.
However, this may have kept you looking long on the pullbacks which should have produced a decent winner on the shorter time frames when the market retraces early on, but this should show you why first and foremost you must decide if you are going to use highest close or highest high. Everything changes based on how you determine the starting point and this must be decided before not during the process. If unsure, remember the majority uses highest close. This is just one more part however that comes down to you trading what works for you.
The green box is when the bearish trend turns bullish. At this point, price has retraced 20% from it’s lowest close and the market goes long for the next 8 years. Notice the two corrections that happen in 2010 and 2011. This should show you that corrections can happen quickly after a market trend changes and they happen on average once per year.
Now that you’ve seen this in action, let’s look to the present.
The SPY must reach $257.92 to enter a correction. This means even as nasty as this roughly 5% pullback is, it’s still just a pullback. The fact that this did not happen in 2017 should not scare you because it’s finally happening in 2018. It’s just part of trading and should be expected, not feared.
The SPY must reach $229.27 to turn to a bearish trend. Remember, if price closes below $229.27 on a daily time frame, the market will officially be bearish, but this doesn’t mean you should expect it.
In the current state, the market is in an aggressive pullback. While it may be tempting to throw up a #BTFD and get in there, stop, and think. Ask yourself is this part of my plan? If this a % based buy or simply looks enticing because at one point it was $285?
The key to trading this properly is knowing what your plan says, and sticking to it.
If you have a plan, and know how you’re going to trade this type of pullback, then the last thing to do is recognize that you have to ignore the noise.
On Social Media, there will be plenty of bears saying this is it. This time it’s it. This time everyone’s going broke. While it very well may be, it seems strange to bet against the US, but maybe that’s just me.
Next time, instead of paying attention to that noise, trust your plan. Trust the knowledge you’ve gained knowing the current numbers the market must hit to truly change course. Understand that if new highs come, these numbers again change. Always based simply on the 10% and 20% rules. And finally, as always, only trade what works for you by trading your plan.
If you are unsure of what to do with this new information, head over to our strategies section and learn the price channel breakout. It’s must easier to buy the dip when it’s making a new high on a smaller timeframe. If you liked what you learned today, make sure you join the CTP Group to get more information just like this every few weeks. And last but not least, Trade Your Plan. It’s the best edge you’ll ever have.