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CORE RISK MANAGEMENT: Using Key Price Levels & MAs to Avoid Major Downtrends

Markets move quickly, and the S&P 500 is -7.8% over the last 5 days, after making a new all-time high on February 19. I can absolutely state this, by using price levels to manage positions and not emotions or predictions, if markets trend back to the upside, I will be long and if they start to unwind to new lows, I will be in cash or short. It is not a prediction or an opinion, or alot of emotional decisions to make, it is a price based trading process.

If Price > x, Long and < x, Cash or Short.


Volatility and uncertain returns are one of the many reasons that stocks offer higher than average returns over time. I started trading in 1998, and my first two Bear Markets were 2000 and 2008, each down over 50%. I am in no way implying that we will go into a Bear Market at all, because I don’t make predictions, but I do have considerable experience with fast moving ‘down-markets’. The lows can come in very fast and at any time, whether it is today, next week or down the road. My plan is to manage any potential drawdowns, whenever they happen.

Here are a few ideas on how to handle higher volatility and sharp pullbacks:

1/ Have predefined downside risk levels.
I follow price, moving averages and uptrends. As long as my positions and/or markets are trending higher, I follow the trend. Staying long or adding in pullbacks works until it doesn’t. I always have a key downside risk level below, either a key longer term moving average, which for example could be the 100-day, 150-day or 200-day moving average, or a key price level, in this case we can use $SPX 3200 as an example. In this example, under 3200 I will be in ‘minimize drawdown/no new positions’ mode and over 3200 in ‘long-side ideas’ mode, always with stops and risk controls. What I want to do is avoid any potential major drawdowns, if markets unwind.  

As long as prices are trading above the pre-determined moving average or price level, then the focus leans into looking for upside ideas and managing the uptrends. Defense is an every day priority, but in the strong uptrends, offense is a priority as well. If price breaks below my key risk level, then the focus shifts to managing downside risk, minimizing drawdowns, and managing exits.

2/ Don’t chase downtrends or try to call ‘the Bottom’
Once price is below the key risk level, I am going to stop trying to buy the pullback, and stop taking new equity positions, because I don’t want to buy into the downtrend. Buying a lower-volatility pullback in an uptrend is a much different process than buying a pullback into a higher-volatility downtrend. Once the steeper selling starts, the goal is to minimize the drawdown and minimize volatility. The rallies in downtrends can be very sharp. If price closes back above my key price level or moving average level, than I can reevaluate the directional focus. I would much rather pay more to buy on the way back up, then pay less to buy into a downtrend.

Many have tried to ‘call the top’, and that strategy has cost them dearly over the last few years, as it is a very low win-rate idea to try to call major market tops and bottoms. Trying to call the bottom in a sell off is just as questionable of an idea. It is better to let price give signals as to when a low might be in.

3/ Don’t try to be a Hero – Honor stop losses, have patience and sit on cash
I use pre-defined stops and exits on positions. Once they start to go off, that is the markets way of reducing the risk in the accounts. Instead of trying to find the next new buy, I let the stops go off and the cash build in the accounts. Having higher levels of cash in drawdowns is a great way to preserve mental capital as well as financial capital.

Our Blue Chip Daily Model Account ended last week at over 20% cash and 12%+ US Treasuries, and is at 34% cash with this week’s exits. High cash levels reduces drawdowns and volatility and offers a less pressured decision making environment. Watching a downtrend play out while sitting on a high cash level is a favorable position to be in. 

4/ Watch Daily Volatility
I use Average True Range (ATR) which is a simple calculation of the daily trading range for a security. When ATR starts to expand, that is a sign that volatility is picking up, and is often a sign of a bigger move to come.  I focus on Price, price levels, moving averages and ATR, because none of these is predictive, they are basic calculations of price.  If a moving average breaks down, or if ATR expands, these are simple to see, there is no interpretation required, as with chart ‘patterns’, and no prediction needed. Price is either above or below a moving average, ATR is either expanding, flat or contracting, it is black and white. The $SPX chart below shows ATR expanding into this move, from under 20 in December to over 30 in February and currently at 43. When ATR is expanding, this is a sign of higher volatility.

5/ Only trade your Egde – When in doubt. it’s OK to sit out
Traders get paid to make money, not hit the buy and sell buttons all day long. Some traders thrive in higher-volatility environments and can trade them well, some do not. If one is not highly skilled at shorter-term, higher- volatility trading, than it is best to sit it out until market conditions come into their skill zone. In many market conditions the concept of not losing money is just as good, if not better, than trying to make money.

6/ Limited Testing 
At some point, if I see what appears to be a possible technical low, either by testing key support, a key MA, price signal or a selling climax, I may use a ‘test position’, usually an index ETF, with a tighter than average stop level. If the low is in, the ETF will start to work and then I can manage it on the way up. If I am wrong in the position, the stop will get me out with an acceptable loss and I will reevaluate.

I do not want to see signs of a possible low, and then add multiple positions, a few ETFs and a few stocks because I see that the low might be in. It is much easier to focus on and manage one concentrated ETF position in volatile markets, than a basket of them or stocks. Single stocks are much more volatile in higher range times and the opening gaps can wreak havoc on stops.

7/ It is OK to wait
For many, instead of trying to find the technical low, another strategy is to wait for confirmation. This is the same as downside level triggers, but in reverse, upside trigger levels. A trader might set a rule that they won’t add new money until price recovers by X% off the low or closes over a key price level or moving average overhead. This is a practice that many skilled traders use.

8/ Do less, not more
Higher volatility and downside testing for me means less activity, much more cash, and smaller positions, if any. If a pullback turns into a steep downtrend or a Bear Market, than Cash will outperform most by a wide margin. Nothing beats high cash levels in a downtrend or Bear Market.

9/ Hedging & Shorting, Pros and Cons
Some advocate hedging, which may have advantages and drawbacks. I won’t go into advanced hedging strategies, only basic concepts. The most basic concept of shorting an index vs a basket of open long positions may reduce drawdowns, but not always. In the September 2019 drawdown and 200-sma test, many indices hardly budged at first, while single name high momentum tech stocks unwound 20-30%+. Anyone holding a basket of these momentum stocks saw their holdings unwind rapidly, while the index hedges hardly moved, creating no protection. The only true safe haven is green Cash. 

Adding more exposure, say an index short, also means more decisions. If someone holds an index short and the market rallies X%, they may cover their short at a loss, only to watch the market then head lower and create more of a loss. Open positions equal more risk to manage. By far, Cash is the best hedge. 

While I am not advocating for or against hedging, one needs to understand the nuances and not just assume they are protected because they think they are hedged. When I do hedge, a simple index ETF short works best for me.

Shorting is a different skill set as well, and one that took me a long time to become proficient at. My view is that the majority should avoid shorting at all, or wait until they have been consistently profitable on the long side for a few years. Trading short is a completely different skill set than trading long, especially in highly volatile markets.  When I do short, I prefer an index short in a downtrend, as was the case in Q4 2018.

10/ Summary
Markets go up and down, stocks go up and down, and often down much faster than up. This uncertainty is part of the long-term return potential of stocks. It does pay to know when to shift the main focus from offense to defense, and when the focus shifts, it pays to have a well thought out plan and alot of patience.

The lows can come in at literally any time soon or no time soon. Let price levels determine the trading plan, not emotions or opinions.  Once the selling is done, whether it is in one day, one week, one month or one year, there are often very good longer term opportunities that come up, for those who are in a position to take them. I keep a watch list and key buy levels of my top ideas, so that when the time comes, I am trading my plan, and not just chasing random symbols. Winning in markets is a lifelong endeavor for many, so it is a marathon, not a sprint. Very few get rich overnight in markets, but many can go broke in a short time frame if they do not have skill, discipline and patience. Once we learn how to manage the downside and drawdowns, and let price levels manage the process and not emotions, we take the next major step to long-term success.


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