4 defensive strategies for anxious investors

MIAMI, Fla. (MarketWatch) — If you’ve been following the market, you know that it’s resembled a wild roller coaster ride. Although selling in May was exactly the right move, when to get back in is less certain.

At the moment, the charts look dreadful: the major stock indexes are well below their moving averages, and other technical indicators signal dangerous conditions. For insights into this volatile market, I spoke with trader Toni Turner, author of The Beginner’s Guide to Day Trading Online (2nd Edition).

A few months ago, Turner noticed that the market was changing for the worse.

“Starting with the rebellion in Egypt, the stock market was rising but the weekly candlesticks were getting wider and wider, which reflects indecision,” she said. “I also looked at an indicator called Average True Range (ATR). When it started to rise, it suggested it was time to be defensive.”

Volatility knocks

Many people falsely believe that all this volatility is good for day traders. In fact, it’s difficult to make money when the market is making double- and triple intraday reverses. “Even one rumor can make the market turn on a dime,” Turner said. “We now have a headline-driven market, and it’s not based on the fundamentals of a sound economy.”

Because of the extreme volatility, it’s often difficult for traders to book profits. “For example, if there is a rumor that China is buying Italian bonds, the market shoots up,” Turner said. “The next day, traders discover the rumor is false and the market falls. Traders who are close to the information have already gotten out.”

When the market is this confused, Turner suggested a number of defensive strategies to use:

1. Determine who is the ‘boss du jour’

There’s always an underlying force that influences market direction. Identifying what is moving the market can help you be on the right side of the trade.

“My strategy is to establish what dynamic is leading the market,” Turner said, targeting what she calls the “boss du jour.” In the past, oil led the market, and often it’s the S&P 500 Index or Dow Jones Industrial Average futures.

“Right now the euro is the boss,” Turner said, “and it’s having a rough time. If the euro moves down, the market will often follow.” In the old days, U.S. traders didn’t pay much attention to the global markets, and few paid attention to the European Central Bank or unemployment in Germany. Now it’s a global market, and astute traders study world headlines for clues.

2. Use charts to identify congestion

One of the most basic skills in technical analysis is learning to identify confusion, or congestion.

“Congestion on a chart is a series of stops and starts on a chart,” Turner said. “Right now we see this congestion on stocks that are normally docile. I can’t relate this to any recent period in history. It’s a mess. If you look at the defensive ETF sectors such as XLU (Utilities SPDR), it’s usually a yawn, but when it’s acting like a tech stock, you have to wonder what is going on. Some of these stocks look like a kangaroo on speed.”

3. Avoid overpriced growth stocks

Although Turner is a trader, she studies stock fundamentals such as the P/E ratio, debt levels, and earnings.

“Don’t buy an overpriced growth stock with bad fundamentals,” she said. “These stocks were probably ‘bid up’ by traders. More than likely, there are hedge funds just waiting to short them on the next market downturn.”

Turner suggests taking a look at value stocks, especially if you are bottom picking. “Value stocks don’t usually get hammered as badly as growth stocks, when we experience a downturn.”

4. Pay attention to chart patterns

Not everyone believes that chart patterns are useful, but Turner disagrees.

“Patterns are human behavior on a screen,” she said. “Greed, fear, optimism, and anxiety are displayed. So when I see a bear flag pattern with wide candles being drawn on a chart with big gaps, it tells me the people trading this stock are confused and in disagreement. This is what I see on the SPY right now, and it’s been like this since August.”

Parting words

For now, Turner suggests that rookie traders stand aside and take a breather. “It’s a difficult, headline-driven market. If you’re wise and try not to outthink the market, you can remain in cash for now. When the market starts to go our way again, you’ll have money to trade.” Read more of my interview with Toni Turner

When the market is this confused, staying on the sidelines makes sense. The war between the bulls and bears continues, and eventually one side will win. Until then, patient traders must wait for an opportunity to pounce. Unfortunately, that opportunity has not yet arrived.

Michael Sincere is the author of Start Day Trading Now (Adams Media, 2011), All About Market Indicators (McGraw-Hill, 2010), and Understanding Stocks (McGraw-Hill, 2003).

Interview with Shah Gilani

The following is an interview I had with former hedge fund manager Shah Gilani. He is also a contributing editor to bothMoney Morning and The Money Map Report.

Q. Would you say that Wall Street is transparent right now?

Gilani: No, it’s not. It’s confusing to investors. The average investor is not privy to how it really works. If you don’t know what is woven into that cloth, then it’s hard to tell what kind of quality it’s going to be. You can’t tell. Investors know there is a problem but they can’t put their finger on it. The problem would be self evident if they had an understanding of values.

Q. What do you see in the market right now?

Gilani: I see more volatility, particularly in the global markets. Debt is the problem in the global picture. The market is incredibly dangerous right now. Although investors want to make back their money, they also don’t want to get duped. They don’t want to be used as a backstop. Sadly, though, many don’t have a choice.

Q. What should investors do?

Gilani: Right now you have to cherry pick stocks. You also have to be an investor-trader. You have to be proactive, and look at your portfolio every day or two. You can’t wait a month anymore. The days of buying and falling asleep are over. You also have to put in stops, and have profit targets. And as your stock goes higher, raise your stops higher. That way, if the market falls, you can get out. The market moves so fast you could lose all of your profits in a matter of days.

Q. What is the problem with the market right now?

Gilani: The market is unfair but it doesn’t have to be that way. In my opinion, volatility has been engineered into the financial markets for the sake of Wall Street and traders, and to the enormous detriment of the public, investors, and the economy.

Q: Could you expand on that?

Gilani: Capital markets are set up to serve to raise cash, equity and debt, to facilitate business development, and to provide liquidity to investors providing financing so businesses can grow and share the wealth. Wall Street was set up to be the capital market’s intermediary, but they realized it’s better if they could be principal risk takers as well as market makers. Then they can trade their own book against the market, which includes their clients. Wall Street doesn’t like a calm market. There isn’t a lot of money to be made when volatility is low and spreads are super tight. In the old days, the market was calmer, which was bad for the traders on Wall Street.

Q. How did they change the system?

Gilani: The first thing they did was eliminate fractions. At the time, it seemed to make sense. After all, fractions came from the days when the Spanish, for example, cut up silver and gold into “pieces of eight.” Unfortunately, by moving to a decimal system, it destroyed liquidity by greatly reducing the “depth” of bids and offers investors were once willing to line up to execute. That changed the market. And now Wall Street specialists and market makers, instead of risking an eighth or a quarter, only risk a penny if they step in front of any client or book orders to try and profit themselves as a principal. Everyone seems to think that decimalization was good for the markets.

Q. Was there anything good about decimalization?

Gilani: The only positive was that transaction costs came down. Another problem it created was that no one knows where the liquidity is anymore. When specialists and market makers can step in front of client orders to take their positions essentially from them, it caused traders and institutional players to look for different venues. Now many high volume traders are going into hidden venues like dark pools. This is not good for investors or traders who don’t have the same access to multiple venues, or the market, but it is good for the Wall Street players. Instead of making the market more efficient for everybody, it decreased liquidity for the general public and increased volatility.

Q. Any other rules that caused problems?

Gilani: Eliminating the uptick rule was another mistake. The uptick rule was working just fine until they took it away. When you think back to all of the rules that Wall Street changed since the eighties: deregulation, decimalization, the uptick rule, allowance for multiple venues, no central order handling book, and the blind pools, it all adds up to a trader’s game. Wall Street is no longer facilitating A and B in the capital markets, but is all about making money for themselves now. That is why the Occupy Wall Street people are protesting. They know that something is wrong, but they don’t know what. They don’t know why they are protesting. Instead of a level playing field, all of the investors have been leveled. The tail is wagging the dog now.

Q. What’s the solution?

Gilani: We have to start looking at what is good for the economy and investors, not just Wall Street. But banks and lobbyists are pushing back. They don’t want the rules to favor investors. Let’s see what happens to the Volcker Rule, which will keep banks out of the securities business. We’ll see if that ever gets implemented as it was originally contemplated.

Q. Are there any other ways to stop the shenanigans?

Gilani: Wrongdoers should be punished. If fraud was done on purpose, and you made a lot of money and caused pain, you should not be able to walk away and hurt the economy and investors. The first place to hit them is in the wallet and claw back that money. If you do it legally, go for it. But if it was illegal, and you manipulated the system, then it’s fraud. If guilty of the crime, you should do the time. Make certain things are punishable by prison time. If guilty, they might even have to sell that second house in the Hamptons.