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Don’t Get Caught In A Bear Trap

The market has been decidedly weak so far in December and despite an upbeat jobs report, we are seeing a consolidation in prices across most of the major indices. This consolidation can be healthy given the height of the market and the incredible run that it has undergone since we began the year. However, it is also going to give some hope for the bears that we will see at least a short-lived sell off before we close the books on 2013.

With the percentage of bears near historical lows, it only makes sense that there are fewer buyers in the marketplace. When you add in the potential for tax loss selling and profit taking before year end, it starts to become easier to convince yourself that the top may be in.

I know more than a few investors that are going to be licking their lips for the chance to indulge in a guilty pleasure to short the market from the highs. Those that have missed the rally will be itching for an opportunity to make up that money on the downside. With the advent of inverse ETFs such as the ProShares Ultra Short S&P 500 ETF (SDS), this endeavor has never been more accessible to the average trader.

Personally, I am not a huge fan of trying to call a top in the market and looking to employ leverage to enhance your returns by betting against the crowd. My experience has taught me that most retail investors find themselves entering inverse positions at the wrong time and for the wrong reasons.

I have only met a handful of steely traders in my career who have the time, tools, and discipline to consistently profit by shorting stocks. These traders have the uncanny ability to set aside emotion and look at an opportunity from a completely objective perspective. In addition, they are quick to cut their losses if the tide turns against them.

More often than not, I talk to investors and clients that end up getting caught in a bear trap that sends a portion of their hard earned nest egg up in smoke. For those that aren’t familiar with the terminology, Investopedia defines a bear trap as:

“A false signal that the rising trend of a stock or index has reversed when it has not. A bear trap prompts traders to place shorts on the stock or index, since they expect the underlying to decline in value. Instead of declining further, the investment stays flat, or slightly recovers.”

When I examine a one-year chart of the SPDR S&P 500 ETF (SPY), I am reminded of why I try to avoid using inverse ETFs in my client accounts. There were several instances of 2-5% pullbacks in 2013 that ended up being buying opportunities rather than shorting opportunities.

In addition, if you were not careful to put a tight stop loss on your inverse trade, you were probably stung for double digit losses in a very short period of time. Those types of mistakes can quickly hinder your total portfolio performance during a stellar year like 2013.

Some Guidelines To Follow For Shorting The Market

  1. Make sure that you are using a tight trailing stop loss whenever you are entering a short position. A small loss is much easier to make up for than a big loss that can set you back months.
  2. Shorten your time frame when using leverage or inverse positions. Instead of months or quarters, you should be thinking in terms of days or weeks for entering and exiting positions. Stay nimble and take profits when possible.
  3. Use smaller position sizes when you are shorting the market as a way to limit your exposure. Your allocation size will determine how much you are willing to risk.
  4. Remember to stay as balanced and unemotional as possible when shorting the market. Don’t get overly confident when things go your way or too depressed when it doesn’t. Keeping your emotional capital (confidence) intact is just as important as your investment capital.

The most negative market watchers will always try to convince you that the next 2008 financial crisis is right around the corner. While it very well may be, I would prefer to transition my portfolio to cash, fixed-income or other non-correlated holdings to ride out that storm. I won’t get overly concerned about a new correction or bear market until we see a dip below the long-term moving averages. For now, I am continuing to monitor the price action of market and actively looking for new income and growth opportunities that may present themselves.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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