Why Mapping the Mind of the Market Matters
“It's insane to expect a trading system to work in all market types.”
- Dr. Van K. Tharp
This past weekend, I reread Jack Schwager's classic book, Market Wizards: Interviews with Top Traders.
Although first published in 1989, the book's wisdom of world-class traders like Paul Tudor Jones, Bruce Kovner, Ed Seykota and Michael Steinhardt remains eternal.
Rereading these interviews always reminds me of the dedication, discipline and flexibility it takes to be a profitable trader.
It's that last characteristic - flexibility - that took me the longest to learn.
Just because you have an investment strategy that's worked well for a long time doesn't mean that same strategy will work in the future.
That's because change is the only constant in the financial markets.
And if the character of the market changes...
Traders (and investors) must adjust their trading strategies as well.
How to Map the Market's Mind
Investors have been spoiled by the U.S. stock market over the past two years.
Markets have been trending up. Volatility has been low.
Merely staying invested in the stock market has worked wonders in a quiet, bullish market.
It's the kind of market that makes the average investor look like a genius.
But as the old Wall Street saying goes... never confuse brains with a bull market.
As the last two months confirm, it's a lot tougher to make money riding the market's momentum when that momentum fades.
One of the most important lessons I've learned as a trader is to identify "market types."
Here's the way I like to think about it...
There are three primary market types: bullish, bearish and sideways.
And different strategies work for each market type.
So how do you identify today's market type?
Sure, you can use formulas, calculations and arcane technical indicators.
But I prefer good old-fashioned common sense.
Or as Justice Potter Stewart put it in his definition of pornography... "I know it when I see it."
Take a look at a chart of the S&P 500 over the past six months...
The S&P 500 was in a low-volatility, bullish phase up until the end of January.
The market went up steadily almost every day.
And then on January 29, the bull market got the rug pulled out from under it.
Since then, the S&P 500 has traded sideways.
Instead of offering a smooth and steady ride upward, the market became choppy and more volatile.
Is it any surprise strategies that worked up until then have stopped working since?
Trading Different Market Types
I like exchange-traded funds (ETFs) for many reasons.
They allow you to invest in assets you couldn't otherwise invest in, like timber and private equity, for example. They also allow you to trade a wide range of market types.
I like to think of investing in stocks and ETFs in terms of playing checkers and chess.
If you just buy and hold stocks, you are investing along a single dimension.
That's a strategy that worked well enough in a low-volatility, bullish market.
But it's also like playing checkers... All of your pieces are the same, and (with one exception) you can move in only one direction.
In contrast, investing in ETFs is more like playing chess... That's because ETFs allow you to invest in other asset classes besides stocks.
You can invest in bonds, commodities, currencies and global markets.
Like individual chess pieces, each asset class moves according to its own unique set of rules.
Specialty ETFs allow you to take this flexibility one step further...
You can buy an ETF that "shorts" the stock market - that is, profits from market downturns.
You can even short the market with leverage - generating two or three times returns from a market decline.
Like Mr. Spock in Star Trek... you can play three-dimensional chess.
How to Profit From a Sustained Market Downturn
Say you want to short, or profit from, a drop in the Dow Jones Industrial Average.
To do so, you can buy the ProShares Short Dow30 ETF (NYSE: DOG) - a straightforward bet against the Dow.
If you're particularly bearish, you can buy the ProShares UltraPro Short Dow30 ETF (NYSE: SDOW), which doubles the rate of return on your bet against the Dow.
Over periods longer than a day, your returns can vary significantly. Nevertheless, the broad direction of these ETFs remains intact.
The obvious question arises...
Should you short the Dow by buying the ProShares Short Dow30?
As of this writing, the U.S. stock market is still locked in a trading range.
I'd consider a small position in the ProShares Short Dow30 if the Dow falls below both its 200-day moving average and the 23,000 level.
So we're close - but not quite there yet.
Thoughts on this article? Leave a comment below.