Don't Live (and Trade) in Fear of a Market Doomsday: Just Have a Plan

One of the best ways to garner attention in the media is to pound your chest loud and never sway from your view. To add to it, sell fear more than greed. People gravitate toward fear. It is human nature.

That's also the same reason a money manager or market prognosticator can call for an epic stock market crash year after year, be wrong, yet still be followed and receive airtime. They will accumulate a devout group of followers, doomsayers of the market if you will, that will defend the thesis to their last penny. Then, they'll borrow pennies from the tray next to the register at the gas station, and use those until they're gone.

Guess what? One day, they'll be right.

Maybe only a handful of them will survive to crow they were right. Maybe it will be the next batch of doomsayers that will get to make the claim, but I'll go out on a limb and say none of the followers are getting rich from it. The only wealth that's created is by the "leader," and it will come from some place other than trading the doomsday call.

Unfortunately, this rhetoric will keep investors on the sidelines while they watch markets rise. They are worried about investing the day before the end of the world happens.

Two things: 1) If the end of the world happens, your investments likely won't matter much; 2) Unless you also don't go outside for fear of being attacked by a shark or getting struck by a lightning bolt, then you can't live in fear. Instead, simply have a plan.

For investors just beginning by using index ETFs, all you need to do is establish your risk tolerance (then cut it in half since we seldom can tolerate what we believe we can without experiencing it first).

I know not everyone loves charts, but there are a few indicators that offer some nice risk management ideas and they are very simple. I'd start by checking out simple moving averages, price channels, or trailing stops. I'm including a few charts for reference.

Moving Averages

Depending on your investment time horizon as well as your risk tolerance, a daily or a weekly chart may be a better fit. The approach here is basic. Select a moving average that maps well with your risk tolerance.

Visually, you can get an idea by viewing how far apart price and the moving average are in a trending market (that's when they will likely separate the most).

The 2017 time frame gives us a great example. You'll see how the purple (21-day SMA) is close to price while the green line (200-day SMA) is much further away. Using the purple (21) or blue (50) line would result in quicker stops (smaller losses) while the longer periods result in both more upside and more drop before a stop. While the longer time frames worked better in 2017, they were more volatility. Again, I would only select one or two.

On the weekly timeframe, the chart becomes less cluttered when viewing three years. While the 8-week SMA (green line) is likely too active for most folks, the 21-week SMA worked well in terms of stops. I would be looking at 8, 13, or 21 if I were just getting starting. The 50-week is simply too wide, but if your time horizon is 20 years, then it might suit you.

Price Channels

Another approach is to use a price channel. On the chart, below, I depicted a 10-day price channel, but again this can be adjusted to your timeframe.In terms of a stop, an investor or trader would simply use the bottom of the channel, which depicts the high and low from the past X number of trading days. In the case of this example, 10 days. It's not my favorite, but workable.

On the weekly timeframe, below, I would definitely keep it to 20 weeks or shorter, more likely 10 weeks on a closing basis. I could even envision some traders using five or eight weeks to only focus on the strongest of trends. I've found anything beyond eight weeks can still result in some nasty drops before getting stopped.

Trailing % Stops

There are no charts needed for this idea. The concept here is to set your stop at a set percentage below your entry. Then, each time the stock closes above your current level, you move the stop higher, but NEVER lower. Your stop will ratchet higher along with a stock moving higher to limit the risk of giving back all your gains. This could be done on either a daily closing or weekly closing basis.

There are obviously different approaches with each such as trimming positions as they rise, but I'm only examining the most basic approach to stops. While this won't eliminate gap risk, for traders sticking with index or sector ETFs, the diversification within those already provide a measure of limited gap risk. For individual stocks, this approach still works, but I would take an extra step during a catalyst event such as earnings.

I hope this helps a few folks and I hope you have a wonderful weekend.