Fair warning, this is a long post, but it is critical information for your trading health in this new bear market and it is absolutely worth your time to read it! It is Adrian here, and as I write this (19th March 2020) we are in the middle of the Corona virus / Oil Price Crash induced bear market. Now I promise that is the last time I will mention the virus because if you are anything like me your inbox and social media is packed full of that hysteria. Instead, I want to focus on how you can position your trading and your trading systems to make the most of the current market conditions. The first step is to see things exactly as they are, not better than they are with excess optimism, and not worse than they are. People who are seeing things better than they are right now will be saying something like:“This is way overdone and all of these stocks down 30-50% are an absolute bargain… I will make a killing when these recover over the next few weeks so I have to buy now!” People who are seeing things worse than they are will be saying something like:“This is going to be the next great depression, stocks are going down another 50% from here and I better short everything because this is going to collapse real soon!” Contrast this with the stock trader who sees things exactly as they are who says something like:“The S&P500 index is now down 32% from its highest point in the bull market and volatility is at an all time high. My account is in a 25% drawdown and my long exposure is 15% and my short exposure is 30% or my account.” As traders we have to start with the current FACTS in a calm and emotionless way. With so many people running around in a bear market losing their head, only the calm can survive and profit! No matter how clever we are as traders, we can’t predict the future. All we can do is position ourselves for likely outcomes and then respond to what the market does. No matter how high our conviction is we can never be 100% certain what outcome we will end up with. Because of this the best way to think through market turmoil is using scenarios. In The Trader Success System I use a great framework called the Market System Map to think through the possible market scenarios. Here it is summarised into a single image: According to The Market System Map, there are 9 behaviours the market can exhibit… no matter how crazy the world seems or what is happening in our account, there are only 9 possible behaviours. As a trader, I find this simple realisation very calming and empowering because it means we don’t have to anticipate what crazy things are going to happen out there in the real world… all we need to do is prepare for the market behaviours that occur as a result. So where are we and what can happen? Well it is safe to say we are in a Bear Market. This means that there are 3 possible scenarios from here:
- The bear market continues and prices fall further
- There’s a shock against the bear market which then continues
- The trend can change to either:
- A sideways, probably volatile trend
- The trend reverses and we have a rapid recovery
- Limit the total exposure you allow your mean reversion trading system to take to a small percentage of your total trading capital. For example I only give mine up to 30% of total capital… even this may be too high so consider a 15-30% allocation for example depending on what other stock trading systems you have in your portfolio.
- Ensure your position size is small. For mean reversion I like to use Percent of Equity position sizing so all positions have the same exposure. That way I don’t get hurt by a large position that craters from bad news. I can’t stress enough how important small position sizes are in volatile markets like this! They are easier to exit, they won’t hurt you as much if there is an extreme move and you will sleep better at night.
- Ensure your system will close losing positions eventually. As I said above, many mean reversion systems don’t have stop losses. This actually helps performance in the long run… This is a bit hard to believe because we all get the importance of stop losses drummed into us from early in our trading career, now Adrian is telling me mean reversion systems are better without stops…WHAT?!?