After we found a bottom from the late January correction at 1043 in the $SPX in early February, many traders became incredibly frustrated with how one sided the market had become when we rallied up above 1215 by late April. Volatility had seemingly disappeared off of the map, as had short sellers who had all but given up on the idea of pushing stocks down. Around that time, going into earnings season, I advocated raising more cash than usual. Since that point, the market has seen increased uncertainty in the form of erratic price swings coupled with spikes in volatility and selling volume. To see uncertainty resonate in the market in the form of volatility usually occurs at inflection points. In particular, after the run we have had since March 2009 and February 2010, it can be seen as a sign of a top.
The question now, of course, is what kind of top? One that lasts a few days, weeks, or quarters? Despite what the Elliot Wave types may say, that is a known unknown. As a swing trader, the most realistic thing I try to do is look for the next direction of the market in the coming days and weeks. As the chart below shows, we have broken our recent choppy and sloppy range on heavy selling volume (note big red volume bars relative to buying volume at the bottom of the chart).
It is a positive for the bulls that we bounced off of the 50 day moving average today, but many traders often misinterpret the purpose of using moving averages in their analysis. A moving average is merely a reference point to gauge the sturdiness of underlying support to the market. To simply say, “when the market hits the 50 day moving average, I will have limit orders in place ready to execute buys,” is not a profitable trading strategy.
Rather, you should watch the action closely to see if the market can stabilize and catch a strong enough bid to bounce off of that general area. It does not have to be a precise bounce. Applied to the current market, we need to see how the market follows up on today’s bounce off of the 50 day. Does it go down and break through? If so, on heavy volume? Or, does it simply consolidate right around the moving average as bulls and bears slug it out? Or, in the bullish case, does the market test the 50 day again tomorrow and bounce sharply higher to close above today’s highs? These are all questions that you should be asking yourself when we come upon a reference point that is closely watched by the majority of traders.
As the title of my post suggests, now is most certainly not the time to turn off your computer and hope that all of your long positions will sort themselves out of this mess in one piece. You never want to panic in the markets, but if you are all-in long at this point, I still think it is correct strategy to sell off your laggards and raise cash into any minor bounce we may get tomorrow. After several months of seeing aggressively bullish strategies handsomely rewarded, many traders are having a hard time shifting gears into a more defensive strategy right now. Although it may seem boring to do so, there are worse things in life than sitting on high levels of cash and waiting for a better investing opportunity, to paraphrase Charlie Munger. Personally, if we gap down again tomorrow I will look to sell out of my remaining short positions in the form of long both $SKF and $QID. I am currently in 65% cash.