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.”
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.”
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).