Last updated on July 6th, 2020
1. Have a backup strategy
One of the smartest things you can do in a down cycle is having the ability to switch to an alternative trading strategy. Or even an alternative asset class. It’s fair to say that many of the strategies out there are designed for a particular type of market only.
Unfortunately, this often comes as a surprise to those using it at the worst possible time. This is especially problematic if that system has delivered consistent profits for a long time.
During the long equities boom that ran till the early 2000s, there were many professional traders who’d never experienced a bear market before.
This gave rise to a widespread attitude of complacency, high risk tolerance and irrational confidence among an entire generation of traders. A rising tide lifts all boats as the saying goes. Stock picking became a no-brainer. If it went up 10% last month, it’ll probably do the same this month.
Having just one tool in your toolbox is not a smart bet over the long haul. It can be very risky.
Knowing at least three or four different strategies will give you much more flexibility. Switch out of that trend following system when markets are going sideways. If your strategy is mostly one directional, long say, look at other techniques or markets that can be efficiently traded on the short side.
Don’t rule out switching to an entirely different asset class either. This can be hard if you’ve invested a lot of time learning that one specific market. Truth is that cash is always searching for the home that will treat it best. That best home is the one that delivers the highest return for the amount of risk taken.
There will certainly be other asset classes benefiting greatly, while the one you are focusing all of your attention on is in the doldrums. One thing to be careful of though is chasing the last hot market.
There will always be ample opportunity in the markets. It is just a case of finding where it is.
You never know how long a down cycle will last. Some down cycles can last for years. And so it is wise to have a broad outlook on the various asset groups and be ready to switch to any of them when necessity rises.
Risk on/risk off events can be a good play if you can time those cycle start and end points.
Gold, safe haven currencies and high grade bonds are historically good risk-off plays. Gold is a little bit more predictable than fiat currencies and can help to diversify risk out of those assets.
Certain currency groups have strong correlation with one another, and that can turn into a problem if your strategy is long or short across too many correlated groups. The same is true for equities where certain sectors will outperform while others underperform as a cycle moves.
Crypto currency is a rising asset class. Investors are still trying to figure out exactly how it fits into the overall tapestry of the capital markets. It is possible that the crypto currency space will itself split out into more localized market groups as time goes on.
The broader your outlook on the capital markets, the easier it will be to find opportunities and jump on them when the time arises.
3. Use downtime time wisely
When markets turn it can offer a good time to reflect on what worked over that period and what didn’t. Naturally, with the benefit of hindsight you will probably look back and wish you’d done things differently.
Perhaps you wish you’d got in on that trend a few months earlier, or got out later!
Trading through a period is entirely different to just visualizing it on the chart. Spotting market highs and lows is far easier with the benefit of hindsight.
After trading through that period you’ll now have a much better perspective on each of those events that moved the market, how they impacted your emotional state and your trade activity.
If things didn’t go well, don’t get discouraged. Use it as a learning exercise.
This can be a great time to analyse and brush up on any shortcomings in your approach. Are you allowing profits to run? Are you chasing losses to much? Are small dips in the market causing you to lose your neve? Are you in control or is the media narrative driving your trading decisions?
If you keep a daily journal, this will be a valuable window into your state of mind and your decision making processes during that period. It makes it easier to rationalize the choices that were made.
In hindsight they might seem to be bad choices, however like most others you were probably just acting on information available at the time.
This is also a great time to review your charting techniques. Did your technical patterns play out in the way you expected? Did you miss any patterns that were giving early warning signals to a changing market? Were there any false signals?
4. Watch for deleveraging events
In times of uncertainty it is just plain common sense to deleverage. Better still don’t get over levered in the first place. Less leverage equals less risk. The unwinding of leveraged positions has the potential to turn a market selloff into a crash.
Being too levered gives you a much higher chance of getting margin called and potentially having your account forcibly liquidated.
While this is bad news for those who are over leveraged, it presents tremendous opportunity for anyone sitting in wait with enough cash in their accounts. Even a small amount of free cash can go a very long way in a market crash when everyone is hunting for liquidity.
There are various recommendations, but a cash allocation of around 20% is prudent. This percentage can increase in times of uncertainty.
Whilst there’s no certainty, most markets do rebound after a sharp selloff. Rebounds are typically of the order of thirty to fifty percent. If you time your trades wisely you stand to make significant profit on your investment in a short period of time.
5. Rebalance your account
A down cycle is a good time to think about rebalancing your trading account. There are always costs to trading, whether that is in broker fees or the time invested. There is also the opportunity cost of the funds you have tied up in the market.
Moving to cash is sensible if you can time that before the market cycle has turned.
If you’ve missed that event, and you’re exposed to falling markets, it may be time to start thinking about profit taking, or cutting losses. This will depend on the type of event you’re facing and your time horizon.
One of the risks of moving to cash is that you miss out on a powerful market move. Longer term holders are less inclined to want to move out of their position for that reason.
This is understandable because the most sizable gains usually happen in fairly brief time intervals; these are regularly in the initial and final stages of a rally.
In this case, an option strategy may be a viable way to allow you to have some exposure to the market whilst keeping cash ready on the side lines.