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Michael Michaud
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Michael Michaud is the founder of Invest2Success.com (http://www.invest2success.com/) and the Invest2Success Blog (http://invest2success.blogspot.com/). He has been investing and trading in the financial markets since 1989. He founded Invest2Success.com to empower individual institutional... More
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  • Why Trading The Short Side Is Different Than Trading The Long Side 0 comments
    Feb 3, 2014 6:42 PM | about stocks: SPY

    Why Trading the Short Side is Different than Trading the Long Side By Market Authority

    When the market enters into a correction phase, the behavior of stocks changes dramatically. I'm not simply referring to the fact that the market is going down rather than going up.

    The behavior of the market is just a function of the way people behave. And the way humans behave when they add risk (buy stocks) differs from how they behave when they want to prevent losses (sell stocks.)

    Let's discuss these two different scenarios - adding risk vs reducing risk - and then I'll highlight how you should approach each phase.

    The process of adding risk correlates with a reduction in volatility. Buying stocks should be a boring process. 2013 was a perfect example of this tendency. As the market grinded higher, volatility (as measured by the VIX) was driven lower.

    Look at the 1 year chart of the SPY vs the VXX (VIX ETF)

    SP500 VIX

    2013, there was a 60% reduction in the VXX, up until this latest rebound in volatility and market pullback. This up move coincided with the latest round of QE, as the Fed effectively reduced stock market volatility. (Based on the belief that it's ok to buy stocks because Bernanke has your back.)

    Furthermore, it's much easier to run trading strategies in a low volatility environment. When volatility is leaving the marketplace, so is correlational risk.

    Ok - I know that sounds confusing so let me explain.

    When macro (the big picture) is imploding, like we saw in 2008, people throw out the "baby with the bath water". That's correlational risk- you may have picked a stock that in normal conditions would outperform the market, however, your stock picking strategy doesn't work when major hedge funds are running "C://SELL EVERYTHING" programs.

    A typical day in 2013 was characterized by a quiet open where the SP's were looking up a few handles and then close 5-10 handles higher. That's what happens when volatility is leaving the marketplace. It's boring and everyday feels like a scene from Groundhog Day. Pullbacks are very rare and shallow.

    Now, however, the tone of the market is changing. Investors are selling and volatility is coming back. But there's one huge difference between rallies and pullback phases:

    Excess volatility works both ways.

    With higher volatility, comes dramatic pullbacks where investors freak out like the world is ending, and then rip-your-face off short squeezes where investors are buying back in like they're life is depending on it.

    Case in point, last week- the Nasdaq recorded its largest single-day gain since 2012. (In the midst of a medium-term pullback!)

    Thus, if you want to make money in a pullback- you need to adopt a more aggressive style than trading a bull market. And here's the mantra of trading through pullbacks:

    SELL THE RIPS AND BUY THE DIPS

    With all of the excess volatility, it makes sense to short on days when the SP's are up 20 handles, and buy them back when they drop 20 handles. Don't be too heavily invested in one side or another, as the market flip-flops moods on a daily basis.

    One other thing to note, a market that opens up or down 5+ SP handles will tend to close in that direction. Full reversals are very rare. If the trend is down in the AM, it usually is down in the afternoon as well.

    Hope this helps, and don't forget to SELL THE RIPS AND BUY THE DIPS.

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