Why do we have to wait for a crash to be safe? A crash is not in our control, which makes it highly risky. A much better approach, which is in our control, would be to focus on stop loss and position size. Below are a few points, which argue that stop loss and position sizing should be an integral part of any trade.
Currently there are few risk related news on the horizon, which can impact the markets adversely. One of them is the Evergrande issue. Others are related to the talks of Fed undertaking tapering measures and US risk of default in October ( The expected default would most likely be avoided by increasing the US debt ceiling).
Below paragraphs will expand on points, which can help you manage a market correction/crash effectively.
1. Check world indices and news
All of the biggest market corrections in the recent past were known from world news. The 2008 downtrend was led by the Lehman crisis and 2020 by the COVID lockdown restrictions.
Thus it makes sense to keep an eye on the recent news. I feel, in recent times the forthcoming US debt repayment event in October 21′, will prove itself to be an early warning. The US needs to increase the debt ceiling in-order to sail through temporarily. However, with so many US engagements in world geopolitics, it makes it all the more difficult for the them to lower the ceiling levels anytime soon. Thus, I expect that the ceiling limit may breach soon. Sincerely hope that I am proved wrong, as it would bring a lot of misery and may even lead to depression.
2. Importance of Vix
Vix depicts the sentiment of the market i.e. fear and greed. Recent COVID lockdown induced market correction led the Vix to breach 80 levels, which has not occured in recent past. More precisely, it is a measure of market’s expectation of volatility over the near term. The calculation is based on the order book of the underlying index options. (‘VIX’ is a trademark of Chicago Board Options Exchange, Incorporated (‘CBOE’) and Standard & Poor’s has granted a license to NSE, with permission from CBOE, to use such mark in the name of the India VIX and for purposes relating to the India VIX.)
3. Tale of advance decline ratio
This ratio will inform regarding the number of shares that have advanced during the period vs number of shares declined during the same period. It indicates potential, existing and the reversal of trends. One can calculate it for various time periods i.e. Daily, Weekly, Monthly. A high positive ratio indicates that market mood is on the upside and a high negative ratio indicates the reverse. Standalone or trend of ratios are used to determine Mr. Market’s mood. Based on these indications, one can choose to go long or short from an intraday perspective.
4. Position size the trades
Position sizing helps to keep losses in check and maintain trading discipline. It simply limits the per day loss according to the risk that one is willing to take. For example, one may decide to only loose Rs 500 and not more in a trade. The entry price is Rs 250 and expected stop loss price is Rs 245. Thus the number of shares that can be bought is 500/(250-254) i.e. 100 quantity.
It is a great tool to manage the volatility risk of the markets. It also allows you to be in a trades longer as losses are limited.
5. Stop loss is your best friend
Any best friend will prevent the other from incurring huge losses on any front. This is the exact role that a stop loss plays. These can be of different varieties. i.e. Time based, Amount based, Price level based.
Price level and amount based stop losses are the most common and base themselves on the an exact price or price range. Stop loss pyramiding is method trailing the stop loss as profits increase.
While a time based stop loss, is a predetermined exit from a trade, if it does not go in favor after a certain pre-decided duration. It is an excellent way to limit risks as it goes with the market mood and serves as an early warning system.
6. High quality stock will always rise
Having exposure in high quality stocks is a safe bet. One can get a sense of a high quality stock by simply checking it’s behavior at the time of it’s worst moments i .e a correction. Most likely the correction would have been minor as compared to the indices for them. The fundamentals would also be top notch for this class of stocks. Other techniques to judge a quality stock are the fundamental ratios and free cash flow availability for future expansion .
7. Do your own analysis
Never ever go by the predictions of anyone other than yourself. You never know the hidden intentions of the person recommending a stock. It is safest to count on your own analysis. Investing resources in learning about markets and forming mental models around trades would serve you well for lifetime.
Hence, it is always prudent to be cautious and not to try and time the markets. But this does not mean that the portfolio will suffer. In fact one can prepare much better for a market correction by following the above points . As the saying goes ‘ A stitch in time saves nine ‘, hence we expect you to improve your understanding of above mentioned risk mitigating measures.
We at Voitto Insights , believe in ‘Teaching a man to Fish’, rather than making him dependent.