The Coronavirus has tanked the stock market from all time highs which has sparked an unnatural combination of pain and fascination for most traders.
The Australian All Ordinaries index made an all time high of 7289 on 20 February and then proceeded to collapse, falling heavily on 10 out of the last 12 days. Today the index closed 20% down from the peak… just 12 trading days after the all time high.
This is probably the fastest 20% decline from an all time high EVER.
The S&P Futures have traded limit down several times.
The Saudi Government just crashed the oil price – down about 30% as I am writing this.
Every stock market index globally was down on their last day of trading… and I am sure every market will be down when they all open after the weekend.
Looking at the list of commodity markets on Bloomberg as I write this and there is nothing but red.
This is really an extreme scenario, and you are probably asking questions like…
“Should I liquidate all my positions and stop following my system”
“How much further can the stock market possibly fall?”
“Should I pull the plug on my trades”
“Do I leave my stops in the market or remove them and just wait it out?”
“What the @?!% should I do???”
I know when you are experiencing financial pain in your account it is hard to be calm and rational, but the first thing everyone needs to do is to calm down and breathe for a few minutes. There is one thing I know absolutely for certain – If you are looking at the markets and your account and your heart rate is elevated, your hands are shaking and you are considering liquidating everything just to make the pain stop… you are emotionally compromised.
When your emotion is high, your intelligence is low… this is a well known phenomena frequently called “the fight or flight response”. This is our evolutionary response to being attacked by a bear – adrenalin pumps into our body and blood gets directed to our muscles to get us ready to fight the bear or run for our lives.
The unfortunate side effect is that our ability to think clearly and rationally is diminished – Survival is the only important thing when being attacked by a bear.
But this last week or two, the bear is not in the physical world – it is in the markets. Survival when the markets panic requires us to override our body’s fight or flight mechanism… because we need to be able to think clearly and calmly if we are to get out of this with our account in one piece.
So the first thing you need to do when the markets get crazy, is to calm your mind and body so your heart rate slows to normal, you aren’t panicking and your hands are not shaking. This is critical because if you make decisions when your emotions are up you will inevitably lose money.
Now onto the more tangible question of “What the @?!% should I do???”.
Advice I gave to one of my Mastermind students today was to think of yourself as an impartial observer… kind of like a scientist observing an experiment. As you observe your market experiment (calmly), divide your thinking and observations into three groups:
- What should you do now?
- What you should you not do now?
- What things should you adjust to make your trading stronger in the future?
It is in moments like this that I am just so grateful that I am a 100% systematic trader. Trading with systems are so powerful because the answer to group 1 “What I should do now” is almost always – follow my system.
When you are trading with a trading system that you have backtested and have confidence in, the answer to just about any trading question you have is to ask yourself “What would my backtest do?”
If you have faith in your system, then all you need to do is follow it.
The great thing about backtesting your system is that over the last 25 years all sorts of crazy things have happened – just like this week (ok, not exactly like this week, but still big drops and volatility for sure). So if you backtest your system through all of that then you know what to expect in weeks like this.
I find that by backtesting my systems and really inspecting the equity curve in detail in times of historical volatility it really helps me prepare for what can happen. In trading there is nothing worse than being caught by surprise!
Some common questions in times like this are:
“I have lost so much already, should I remove my stops and just wait it out?
This is pretty much NEVER a good idea. If the market keeps going down you could end up in an massive hole and take years to recover. If your stops get hit and the market turns around you can always get back in, but if you remove your stops and it keeps going down you will suffer for a long time.
“Should I buy puts to protect my portfolio?”
The trouble with put options as insurance is they are very expensive when you need them most. If your house was already on fire and you called the insurance company to buy insurance how much do you think they would charge you?
The options market is the same way. Because option price is heavily driven by volatility, when volatility is high (like now), option prices are very expensive, so to buy puts now will cost you a fortune. The time to buy insurance on your house is before you need it. The time to think about insurance in the markets is when volatility is low. Buying put options in the middle of a market crash is an expensive strategy. It might pay off if the market keeps falling massively, but chances are you will lose money on the puts.
“Should I dump my whole portfolio and wait till things get better?”
If you are really feeling the pain of the recent market decline this question could have crossed your mind as well. If you are following a trading system then dumping the whole portfolio is basically saying you have lost confidence in the system. If everything about the system’s performance is behaving as expected
(drawdown within historical norms for example) then ask yourself whether you should really have lost confidence at this point.
The only reason I exit an entire portfolio from a trading system is if it becomes obvious that the system is broken and no longer behaving as it should. The way you make this decision is to look at the performance metrics of the system over time and see if they have degraded, and look at the equity curve and see if the
performance (drawdown) is outside historical norms. For example if the system is in a 40% drawdown and the biggest historical drawdown was 20% then it is likely you have a problem!
If you don’t have a system and you are just trading on a discretionary basis then you have a really difficult task here – What you need to do is go back to theoriginal plan you had when you opened the positions. If they were fundamental investments, ask yourself whether anything in the fundamental story has changed
(It could have given the oil price change for example). If they were discretionary technical trades then what exit rules and stop loss were you planning to use? If they have been triggered then I would exit the trades.
I am certainly not a fan of dumping your whole portfolio because the pain is too much – that is a sure way to lose money trading.
So back to my original questions:
What should you do with your stock trading now?
- Check your trading system performance is within normal bounds – if not, consider scaling back or suspending the system while you investigate
- Take extra care with any entries and exits to ensure you don’t incur too much slippage – placing market orders and hoping for the best is going to get you killed at the moment so take extra care and make sure you monitor your orders closely
- If the volatility is too much for you to handle then you should consider scaling back your exposure to keep the daily dollar volatility of your account within comfortable bounds
- If you are getting margin calls then identify which positions are performing worse and which positions are using the most margin and reduce those positions to get your account out of the margin call.
What should you NOT do with your stock trading now?
- Panic and dump positions without a clear plan or strategy
- Change strategies because you have lost money
- Hold onto losing trades to wait for them to get back in the black if your rules are telling you to sell
- Take random trades / tips / hedges that are outside your trading rules and trading plan to try to make back any losses
- Trade more aggressively to try to make back your losses – you will just lose more if you do that
What should you adjust to make your stock trading stronger in the future?
- If you are not trading systematically then the first thing you should do is take the leap and learn about systematic trading. It is a game changer because it takes all the stress out of your trading… you choose a system that suits you, backtest it to build confidence and then just follow the rules and monitor performance.
- If you have a trading system and you are unhappy with how your trading system performed over the last few weeks, then you can either improve your system, select a more profitable system or add a diversified portfolio of systems to profit from different types of market behaviour. If you have several different systems that profit from different market behaviours then you will make money more consistently.
- If you are trading multiple systems already, then review your capital allocation rules to make sure you have the right amount of exposure to different strategies to give you the performance you want
- If you do not have any short system exposure then you should probably consider adding a short system to your portfolio to make money in market declines
This last point is quite critical – There is no absolute right answer about how much of your capital you should allocate to each trading system, so you need to start with your objectives and work backwards from there. In particular the maximum drawdown tolerance is one of the most important objectives to be clear on.
This is a number that varies for everyone… If you don’t have a formal maximum drawdown tolerance documented then just think about the level of drawdown you have experienced before and how it made you feel. If you are getting nervous at 15% then 20% is probably your max. If you are ok at 20% but are starting to think about dumping your positions then 25% is probably your max.
Say for example you are only comfortable with a 20% drawdown at the account level.
Once you have your max drawdown, then look at the backtest of your trading systems, preferably using out of sample data, to see how much drawdown they incur. If you have one system and it has a maximum drawdown of 40% then you are in trouble and you need to reduce your allocation to that system and diversify with some other non correlated systems. If your system has a maximum historical drawdown of 20% then you can’t use leverage because that would increase the drawdown beyond your comfort level.
You can reduce your account drawdown by reducing the capital allocated to that system, by improving the system, or by adding another system which is not highly correlated to the first system. All of these strategies you learn about in The Trader Success System.
One of the best ways to benefit quickly from The Trader Success System is to use The Trading System Collection (which is included in the Trader Success System) to add a new system (or two ro three) to your portfolio to diversify. If you only have long side trend following then adding mean reversion and short systems will help immensely. Similarly if you only have mean reversion then adding trend following and short systems will also help a lot.
The pinnacle of systematic trading is to have many different trading systems that allow you to profit from different markets and different market conditions. This smooths out your equity curve, reduces your drawdown and allows you to stay comfortable and confident no matter what is happening in the market… even if the Coronavirus and the Saudi government are conspiring together to crash the equity markets… if you have a decent short system then the impacts are reduced.
So at the moment in my portfolio the trend trades and mean reversion trades are hurting me, but they are offset by the profits on The Slippery Dip system which trades US equities from the short side. The Slippery Dip turned on last week and is profiting nicely already (Up 10% this month when the S&P500 is down well over 10%).
Too much long exposure and no short exposure will give you big drawdowns in markets like this.
If you reduce your long side capital allocation and give some capital allocation to a short system you will reduce your drawdown in extreme market events like this.
If you have a heavy allocation to mean reversion without a market filter to turn your system off then you can suffer heavy losses and keep entering more and more losing trades as the market declines and fails to mean revert. In this case
having a market filter to turn your mean reversion system off can help, as can
reducing your capital allocation to mean reversion and adding some trend
following and short systems to the mix.
What are your next steps?
Do you want to learn systematic stock trading? Do you want to learn…
- How to make money trading stocks systematically no matter what the markets are doing
- How to backtest your systems to build absolute confidence to follow them no matter what
- How to eliminate discretion and subjectivity from your trading decisions to make your trading more consistent
- How to build a diversified portfolio of trading systems to make money no matter what the market is doing
sound like things you could benefit from then take a look at The Trader Success
System – it will help you take a HUGE step forward in your trading and give you
the confidence you need to trade well no matter how uncertain the markets are!
– You’re only one trading system away