Half-full vs. half-empty: Which market plunges to buy, and which to sell.
“Just because you’re paranoid doesn’t mean they aren’t after you”
― Joseph Heller, Catch-22
The market is plunging, and you are long a stock that is rapidly losing value. Pretty ugly. Pretty uncomfortable. Not very pretty at all.
I can think of something worse: Buying into a plunge when you are sure it has bottomed, then finding out that it had barely begun.
We can define an intraday plunge as a steep decline of more than 50 points in the Dow Industrials within a two-hour period. We can also define a multi-day plunge as a decline of at least a couple hundred points within two days. Really, the definition isn’t so important as your timing window and expectations. The measurement may vary among different timing windows, but every plunge tends at least to produce some discomfort in a trader.
That discomfort is our subconscious warning us – as it should. But we, as traders and portfolio managers, get paid for being uncomfortable. Our subconscious may be warning us to stop acting, just when we should be determining how to capitalize on the discomfort of others. In other words, our minds are telling us to stop but we should keep going on.
When seeing more and more prices turn redder and redder, it is time to determine where the opportunity lies. Assess the plunge by using the following factors that put the plunge into context, so you may act more quickly, more decisively, and more appropriately.
1. The bigger picture. The most important element of a plunge is not the plunge at all, but what preceded it. Is it appearing within a multi-session trading range, contained largely between that range’s upper-end and lower-end? Then that selling pressure is going to be sorely missed, just when it is needed most – upon actually testing the range’s lower-end. Is the plunge appearing in a downtrend (a series of lower highs and lower lows)? Sellers are able to extend lower. Is it appearing in an uptrend (a series of higher highs and higher lows)? That could be a very compelling buying opportunity.
2. Size is relative. If appearing within a multi-session trading range, does the plunge’s size equate to 61.8% of the range’s widest swing? This is a “Fibonacci” measurement. I have found it to be very common among healthy pullbacks that resume their original trend. Much shallower (e.g. 31.8%) would suggest too much optimism remains for a durable bottom to form – a premature reaction up would likely fail. Healthier plunges expend all available selling pressure, without breaking under a prior support like the range’s lower-end.
3. Origination. Did the plunge begin from below a prior low? Then its sponsorship is serious, and bounces can be used for lightening exposure. Plunges that begin from above a prior low are typically only temporary corrections. Here’s a little secret among seasoned managers: big reactions down from new highs often recover, except for that rare exceptional reaction. In a game of percentages, few positions have greater odds of paying off.
4. A slingshot start. Some plunges start the day as a rally. When they reject a new trend high in the morning, note how the reaction behaved upon retracing down to prior highs or prior lows. Look out below if no news can be directly attributed for triggering the plunge. Plunging for the sake of plunging – and not for discounting some suddenly discovered bad news – usually means the rally has run out of buyers.
5. Scapegoat. A reaction to a news item can be as dramatic as the news is surprising. But surprising news is not news that can change a trend’s direction. Knee-jerk reactions to news are by definition temporary, sponsored by weak hands. Plunging back down to prior highs is often recovered quickly. Relevant news will have been long anticipated by market participants that are big enough to change a trend’s direction. The trend will have changed direction already. So-called surprising news is an opportunity to catch a pullback.
Following are several plunges and examples of how the above factors helped to determine whether their setbacks were temporary or just beginning.
Conclusion
Of course, other factors can and should be considered in order to time a better entry into a plunge. Some factors can be complex, like Fibonacci measurements and volume. Your own investment objectives or trading objectives should determine what type of action you will take, and when. But the first step in any case should be to follow the rules for putting the plunge into context, and establish whether it is an opportunity to buy for a rebound, or a warning to sell before things get worse.