How to Trade in a Bear Market

As a followup to my previous column, It Might Be Time to Sell, I wrote an article for Marketwatch on trading in a bear market. Although this market could have a snapback rally, the technical damage to this market has been severe. Being on the short side of this market seems like the right place to be, at least for now. Here is the article:

MIAMI, Fla. (MarketWatch) — One of the most frustrating aspects of the stock market is that by the time you figure out what’s happened, it’s already too late.

To stay on top of the market, be open to when one trend ends and another begins. According to one professional trader, that time is now: the bull market has ended and a bear market has begun.

“The market temperature has changed. I’m seeing technical signals, which we haven’t seen since the 2007 top. This is a bear market, which could last for the next year,” said Dr. Alexander Elder, author of several bestselling books, including “Come Into My Trading Room,” and his latest, “To Trade or Not to Trade.”

Not surprisingly, Elder is short the U.S. market, which means he is selling individual stocks at a high price and planning to buy them back at a lower price in the future.

Another way to short the market is to buy an inverse exchange traded fund, or a bear market mutual fund. If you’re not comfortable being on the short side, you can always move to cash, at least temporarily. And if you don’t want to sell now, you can protect your stocks with stop loss orders.

“I am heavily short,” Elder said, “and I’m loving this market. I switched from a long position to a short position in mid-April. In a series of Marketwatch articles, Elder wrote that the top was when Apple hit its all time high on April 12th. Here is a link to one of his articles: “Three Major Signs the Bull Market has Ended.”

When will Elder be bullish again? Not anytime soon, he said. “It will be an unpleasant bear market but I don’t think it will be a disaster.”

1. Basic trading

A new trader might wonder how to make money in this difficult market environment. Elder has some advice: “Lots of smart people stumble into trading but don’t know the most basic rules. I think a terrible mistake that beginners make is wanting to make money from the get-go…you have to spend time educating yourself.”

Then, start with small positions, perhaps 100 or 200 shares, Elder said. “Money will come later if you play it right,” he added. “A beginner should open an account and trade a small size to learn how to do it.”

2. Diary of a trader

Elder is a proponent of maintaining a trading diary. “You have to keep track of your trades,” he said. “Keeping a diary makes you more thoughtful, and helps you learn from your successes and losses. You become your own teacher.”

He primarily uses technical indicators to make trading decisions, but does consider a few fundamentals. Said Elder: “When something comes across my screen that looks interesting, such as a new technology, it will put me on alert. Then I go to my charts and make the decision to buy or not to buy, to short or not to short.”

Elder doesn’t rely heavily on fundamentals “because they are always late,” he said. “By the time the fundamentals come out, prices have already started to change. That is why my primary attention is on technical analysis, but once in a while an exceptional piece of fundamental news appears.”

He relies on a short list of technical indicators and insists on using two time frames: a weekly and daily chart. “I use the weekly chart for strategic decisions and the daily chart to look for entries and exits.”

3. New High-New Low Index

Elder’s favorite leading indicator of the stock market is the New High-New Low Index.

This index tracks stocks that are making new highs or new lows for a specific time period. Elder uses this indicator to monitor the underlying breadth of the market (i.e. the number of stocks participating in the market’s move).

If stocks making new highs are expanding, this indicates the market breadth is positive, and the market is likely to rise. Conversely, if stocks making new lows are expanding, then market breadth is negative and the market is likely to fall. The most important signal is a divergence, when the market is rising but the number of stocks making new highs is falling.

“The New High-New Low is the single best leading indicator of the stock market,” Elder said. “I’m looking to see if it’s positive or negative, which tells me whether the bulls or bears are leading the market. Also, if the market goes to new highs but the New High-New Low indicator traces a bearish divergence, this is a tremendously dangerous sign.”

In the middle of May, Elder saw his signal: the number of stocks making new highs plummeted (although it’s recovered a bit since then). That brings us back to the beginning: Elder now believes the market breadth is negative, and a bear market has started.

“It’s not unusual to have a bear market,” he said. “The average duration of a bull market is three years, and this bull market started in March 2009. We could have a bear market for the next year.”

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