My first natural instinct was to try and time the turning point of the
panic. I would look at the irrationality and think, “This makes
no sense, when it ends, price will move back quickly in the opposite direction.”
If a market was selling off in a panic I would carefully try to spot the
climactic bottom where I would buy. I was sure the coming retracement
would be a significant move. After this philosophy proved to be a consistent
loser, I began studying the opposite approach.
I developed a few simple rules about trading panics that have produced
a successful approach to these erratic markets. One of the most important
concepts of a panic is that it will most likely get pushed much farther
than one might think it would. I also believe that it is possible to spot
a panic while it is occurring. These are simple points, but they can be
quite powerful. If a panic can be spotted while it is occurring and it
is likely to get pushed farther than seems possible, this means that I
can profit by taking a trade in the direction of the panic.
What is the chance that when a panic is first identified, it was the
very end? In October when did you realize that the market was in a panic
on the daily charts? It is fairly easy to identify these panics well before
they end and reasonable to expect that they can be identified near the
middle of the move.
A panic can be identified by watching candlestick charts. When multiple
candles produce significant moves having little overlap in the candle
bodies with no retracements, this can be considered to be a panic. Basically
price is moving in one direction with a major imbalance of buyers and
sellers. If price is also breaking through a swing point or pushing new
extremes on a longer time frame, this will add credence to the likeliness
that a panic is underway. See the panic below on the SPY 5 minute chart
from December 11, 2008 (starting at 2:35pm).
When a panic has confidently been identified, a stop market entry order
is placed to take a position if the panic moves to a new extreme. Often
times it is beneficial to drop down one time frame and trade on the shorter
time frame. If the panic was spotted on a 5 minute chart consider trading
on a 3 minute or 1 minute chart. A stop loss is implemented at the high
from 2 bars prior. For example assume that SPY is in a selling panic on
a 5 minute chart. It has traded down to 88.65 and is currently trading
slightly above those lows (88.86). A sell short stop market order is placed
at 88.64. A market order is executed when price moves to a new low and
a buy to cover stop market order is placed at the high of the candle 2
time periods prior. This stop is trailed by continuously moving it down
to the high from 2 periods prior until stopped out of the trade.
There are times when discretionary tightening of the stop loss is prudent.
If one of the candles in the panic reaches a length (intra-period) that
is significantly longer than any other candle during the day, the stop
loss can be moved up to within a few pennies of the current price. Usually
the trade will be stopped out quickly. If the panic is in full swing,
price may immediately move down to a new level, keeping me in the trade.
If this happens the extremely long candle is now even longer. Again move
the stop to within a few pennies of the current price until stopped out.
Panics exhibit high volume which means many shares have changed hands;
therefore, many people have recently established new positions. When price
moves to a new extreme, every trader that has taken a position opposing
the panic is now a loser and sees price quickly moving to new uncharted
territory. As those losing traders are forced to cover their positions,
they exacerbate the panic even further. This can be a cascading domino
affect as chaos leads to more chaos. Proper money management practices
include deciding how much money you are willing to risk and determining
appropriate position size based on the location of a stop loss. With sound
money management principals one should not be afraid to enter a trade
in the direction of a panic as price pushes to a new extreme.
Bradley Okresik
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