Trading Strategies for Today’s Markets

Thursday, May 13, 2010

Last Thursday’s 1,000-point air pocket provided an excellent testing environment for various trading strategies. Here are the ones to avoid and the ones to use.

Yesterday’s article, “Wall Street and SEC to Investors: ‘It Wasn’t Us, but We Will Fix It’” (May 12), outlined four weaknesses we have to contend with, concluding:

“So… In carrying out our investment plans, we need to be cognizant of these effects on trading and pricing. Although the current structure has flaws, we can avoid its adverse effects and even use it to our advantage.”

The key problem with today’s stock market structure is the lack of human intervention and controls to ensure that trading is done at reasonable prices. It now appears that even last week’s shakeup will not cause the SEC to reverse its mistaken 2007 moves:

  • Removal of the short-selling uptick rule
  • Allowing NYSE-listed stocks to be traded elsewhere without having to operate under the NYSE’s rules and policies

Therefore, investors must contend with downside volatility when short-selling programs hammer stocks (called “bear raids” before the 1938 uptick rule) and prices are free to roam wherever the computerized “market makers” take them.

Five ways to avoid adverse effects

1. Do not use stop-loss or stop-limit sell orders

In Tuesday’s article, “Wall Street Hits Air Pocket – Two Trading Lessons (Part 3),” I described the problem with such orders: short-term gyrations can take you out of a position. And, in my experience, too often these quick drops are followed by a good move in the opposite direction.

2. Avoid market orders if there is any hint of risk

Last Thursday’s one-cent fills of market orders were extreme and will likely not be seen again. However, drops of a lesser scale can happen if selling suddenly ramps up and/or bids get dropped. So, market orders carry more risk.

Market orders are okay if:

  • The market is not moving sharply
  • The stock being bought/sold has good trading volume, a narrow bid/ask spread and adequate “size” – the amount of shares at the ask (buy) or bid (sell) price
  • -or- The order is for the opening of an actively traded stock. Openings tend to be better orchestrated and prices are reasonable, due to the accumulated buy and sell orders since the previous close.

Otherwise, use limit orders, using a buy limit above the ask price or sell limit below the bid price. These limits are the equivalent of a market order, but ensure that a sudden, adverse price shift won’t affect your trade more than you allow.

3. Request NYSE execution for NYSE-listed stocks

To me, the NYSE has the best execution for its stocks. A while back I was tracking some active trading and was watching the trade-by-trade reporting. The NYSE trades followed a stock’s bid/ask moves well, and larger trades didn’t cause sharp bid/ask or price moves.

4. Don’t watch the market!

I described the problems with watching the stock market too frequently in “Watching Investments Closely Can Blur Understanding and Increase Sense of Risk” (May 3). With the current stock market structure, it is especially important not to get too close. Otherwise, the volatility could disguise the trend and weaken resolve.

5. Be very careful using margin debt

A margin loan requires adequate equity at all times. Heightened downside volatility increases the risk of getting a margin call. This is particularly so if, like last Thursday, a sharp sell-off occurs after the market has already declined in previous sessions.

Two ways to take advantage of wild moves

1. Be “aggressive” at using GTC (good-till-canceled) limit buy orders

With the expectation of periodic downside volatility, keeping a couple of GTC limit buy orders on the books could allow picking up some well-priced stock.

I mentioned using percent declines from highs as a limit price determinant in “52-Week Highs in Today’s Stock Market – Commonplace, but a Useful Buying Tool” (March 24). Here I am talking about opportunistic orders at even lower prices (e.g., 10+% below a high for a steady stock, 15+% below for an average stock, and 20+% below for more volatile stock).

Another approach, if you like using charts and technical indicators, is to place orders below recognized support levels. If they get broken in a sell-off, chances are there will be some automatic selling (e.g., stop-loss orders) that takes the stock down and provides the buying opportunity.

In most markets, these orders will go unfilled. But, in the event of a “downside event,” the GTC orders could provide some nice buys.

2. Be especially alert at mid-quarter

Mid-quarter periods periodically present counter-trend buying and selling opportunities (and we are in one of those periods right now). Therefore, heading into mid-February, mid-May, mid-August and mid-November are good times to ensure those GTC orders are in place.

So… Practicing the steps above should allow us to avoid the adverse effects from the stock market’s current structure and provide some opportunities for added gains.

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