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My name is Ivaylo Ivanov (@ivanhoff). I manage my own money. I am Co-Founder of MarketWisdom.com. Author of Top 10 Trading Setups, The Next Apple, Crash and The 5 Secrets To Highly Profitable Swing Trading

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What Can We Learn about Trading from Warren Buffett and Jeff Bezos

At the beginning of his career, Warren Buffett was a value investor. At some point, he realized value investing cannot scale after certain capital size is reached. Then, he started to buy great businesses at a reasonable price.

I like businesses I can understand. It is not an easy business for competitors to enter. I look for a competitive advantage – cost, brand; share of mind is priceless and better than market share. How much could anyone hurt them if they had a billion or 10 billion dollars. If they can’t make a dent, I am in.

I want to know what a business will look like 10 years from now. If I can’t see them where they will be 10 years from now, I don’t buy them. We are buying a piece of a business. You will do well if the business does well if you didn’t pay too high of a price.

The best thing that happens to us is when a great company gets into temporary trouble…We want to buy them when they’re on the operating table.

Jeff Bezos manages Amazon the way Buffett invests nowadays. He asks the question what is not likely to change ten years from now and builds his operations on those principles.

I very frequently get the question: ‘What’s going to change in the next 10 years?’ And that is a very interesting question; it’s a very common one. I almost never get the question: ‘What’s not going to change in the next 10 years?’ And I submit to you that that second question is actually the more important of the two — because you can build a business strategy around the things that are stable in time. … [I]n our retail business, we know that customers want low prices, and I know that’s going to be true 10 years from now. They want fast delivery; they want vast selection. It’s impossible to imagine a future 10 years from now where a customer comes up and says, ‘Jeff I love Amazon; I just wish the prices were a little higher,’ [or] ‘I love Amazon; I just wish you’d deliver a little more slowly.’ Impossible. And so the effort we put into those things, spinning those things up, we know the energy we put into it today will still be paying off dividends for our customers 10 years from now. When you have something that you know is true, even over the long term, you can afford to put a lot of energy into it.

Both Buffett and Bezos look for long-term sustainable competitive advantages that are very likely to pass the test of time.

Is your trading system developed on principles that are not likely to change ten years from now?

Is your approach based on an understanding that the market is constantly changing and different markets need to be approached with different setups? This requires having a portfolio of different setups and knowing when to use them.

Do you have methods that will find big future winners on a regular basis? The names of future winners will be different than the ones today, but they will have something in common.

Do you have a clearly defined plan to Take advantage of the inevitable market corrections, sector rotations, institutions’ buy and sell decisions, price trends, momentum, volume and price range expansions?

Do you realize that correlations and volatility spike during market corrections and no amount of plain vanilla asset diversification will save your portfolio from a deep drawdown? Are you prepared to stomach 20%, 30%, 50% drawdowns or do you have a way to make them a lot smaller?

Check out my book: Top 10 Trading Setups – How to find them, When to trade them, How to Make Money with them

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The Best-performing Stocks for the Past Ten Years

29 stocks went up more than 1000% in the past decade. One of them is an airline. I guess going to Hawaii has been really popular. Seven of the top ten performers are Internet stocks. The other three are biotech companies. It was the decade of Internet and drugs.

What do all of the above stocks have in common, other than being able to grow their earnings and sales in an impressive manner? They spend a lot of time on the 52-week highs list and set up multiple times. The U.S. stock market indexes bottomed on March 9th, 2009. A couple days later, two stocks broke out to new all-time highs. Both of them went up more than 10x after their breakouts. One was Green Mountain Coffee Roasters, which was acquired in 2015. The other one was Netflix. Netflix went up 44X in the past decade and today it is a 62-billion dollar company. In 2000, Blockbuster refused to buy Netflix for $50 million, because “it was a very small niche business”.

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How to Turn 5k into 30 Million

Home Depot (HD) closed at all-time highs today. $5000 invested in Home Depot when it went public in 1981 is worth about $30 million today.

Turning 5k into 30 million for 35 years means that HD compounded at an average annual rate of 28%.

28% annual appreciation for 35 years is very, very rare. To compare to some of the best-performing stocks of all time: 5k invested in Microsoft in 1986 is worth about $4.85 million today. 5k invested in Walmart in 1975 is worth about 29 million today. 5k invested in Applied Materials (AMAT) in 1975 is worth about 22 million today.

Finding a stock that has the potential to compound at 28% annually for 35 years is close to impossible and probably, it won’t be repeated ever again. Holding such a stock for 35 years might be even harder.

What if instead of finding a stock that can compound annually at 28% for 35 years, you find a stock that can go up 28% this year? And then you repeat the exercise every year for 35 years, one stock at a time? It won’t be easy, but it is also a lot more manageable. Compounding can be magical.

1562 stocks went up more than 30% in the past 12 months. 334 went up more than 100% for the same period.

Check out my newest book: Top 10 Trading Setups – How to find them, when to trade them, how to make money with them.

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Two Themes Have Defined Trading In Early 2017

The major stock market indexes continue to consolidate mostly through time. Small caps are underperforming large caps, which has made chasing breakouts challenging in many occasions. We haven’t seen any strong buying pressure so far in 2017. There has been a little uptick in selling pressure, but nothing major.

Two major trading themes have defined 2017 so far. I don’t know if this will continue to be the case in the near future:

Weak U.S. Dollar, strong emerging markets. The U.S. Dollar is down 2% year-to-date. For the same period, emerging markets (EEM) are up 5.5%, Brazil (EWZ) is up 13%, China (FXI) is up 5%, gold (GLD) is up 5.6%, gold miners (GDX) are up 14%.

Large-cap tech stocks are significantly outperforming. The Nasdaq 100 (QQQ) is up 4% while Russell 2000 (IWM) is down 1% year-to-date.

We have just entered a new earnings season. Thousands of companies will provide new information about the state of their business. As a result, we will see the formation of many new trends, both up and down trends. New trends mean new opportunities.

Check out my latest book: Top 10 Trading Setups – How to find them, when to trade them, how to make money with them.

Check out the 14-day free trial at Market Wisdom.

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137 Stocks Doubled in 2016

137 stocks more than doubled in 2016 (they are currently priced above $4 and trade over 100k share per day). Many of them belong to sectors that no one expected to see among the big winners in early 2016 – oil & gas and industrial metals. Only four out of the 137, had a good 2015 and can be labeled momentum stocks. All others are mean-reversions in beaten-down stocks. This distribution is unique for 2016. There was a major correction at the end of 2015 and the beginning of 2016 and then a major recovery. Most of the best-performing stocks after deep market corrections are the once that got hit the worst during the correction. In most years, the best performers are equally distributed between momentum (stocks that had a great previous year) and mean-reversion (stocks that had a horrible previous year).

Basic materials: 59

Consumer goods: 7

Financial: 7

Healthcare (including biotech): 13

Industrial goods: 14

Services: 14 (mostly airlines, education svs, shipping)

Technology: 19 (mostly semiconductors like AMD and NVDA)

Utilities: 4

Here are the top 15 in term of performance:

Check out my newest book: Top 10 Trading Setups – How to find them, When to trade them, How to make money with them

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The Four Main Reasons You Are Not Making Money In The Stock Market

People have issues with trading for four main reasons:

1. They trade the same setup in every market expecting similar results.Markets don’t work that way. Markets change all the time. Different setups work in different markets. For example, breakouts work amazingly during rising markets, but they will lose you money during range-bound, choppy and corrective markets. When your bread and butter setup stops working, you have two options – find a setup that works or sit on the sidelines until market conditions come back in your favor.

2. They expect to be right almost all the time. This doesn’t happen, even in a bull market. Having a 50% success rate is a very good hit rate. Think about that. If you can be profitable only 50% of the time, how big should your losses and gains be in order to achieve great returns? Not taking a small loss and letting it turn into a big loss has many consequences. The impact on the mind can be even worse than the impact on your account. A big loss influences your future position sizing – you trade small when you have to trade bigger because you are scared. A big drawdown can impact your objectivity and ability to spot and take great setups.

3. They expect regular income from trading. It doesn’t work this way.  Periods of making a lot of money are followed by periods of making no money and periods of losing money. The goal is to keep losses to a minimum and be aggressive only during the right circumstances. Twenty percent of your trades will account for most of your profits. The rest should be small wins and losses that cancel each other out.

4. They trade too big. Most aspiring traders are undercapitalized and they want to get rich quickly. This leads to trading too big, putting all of your money in one small-cap stock, trading illiquid penny stocks, trading options directionally. To sum things up, they trade crappy stocks with a lot of leverage and then they get wiped out quickly.

George Soros and Stanley Druckenmiller became famous for putting 50% or more of their capital into a single position. People assume that they can trade like Soros and Druckenmiller and this is a huge mistake. Never put yourself in a situation where a small market move could shake you out of a perfectly good position just because your sizing was too big. Never let a trade impact your sleep and overall happiness. You don’t want to be in a position where you own two stocks and they are the only two that are not moving with the rest of the market. You should never put more than 20% of your capital into a single stock.

Check out my newest book: Top 10 Trading Setups: How to Find them, When to Trade them, How to Make Money with them

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5 Insights for Aspiring Traders

1. The most important thing is to learn how to learn. Study past winners from different time frames and reverse engineer. Keep a journal, set goals, and work deliberately towards achieving them, one step a time. Improve yourself every week.

2. Less is more. First, learn everything about one great setup – how to find it, when to trade it, how to trade it, when not to trade it. Become a master in trading that setup. Understand that this one setup is not going to work in every market environment, so there will be a time when you will have to stay on the sidelines and do nothing. As you get better at trading your one setup, gradually start adding more setups to your arsenal until you have the right tool for any market environment.

3. Find a mentor who can accelerate your learning curve. There are two ways to learn – from your own mistakes and successes and from other people’s mistakes and successes. You can learn a lot by studying your past trades and reading practical and thought-provoking books and blogs. In most cases, those efforts are not enough. Most people need the help of an outside mentor on their journey to profitable trading.

There has never been a better time in financial history to find a good mentor. There are many tools that could help accelerate your learning and building of trading skills. Some of them are free sources like StockTwits, Twitter, Sparkfin, and various trading blogs. There are also many amazing paid trading services. Find one or two or three that best meet your personality and desired trading style. Try different services that can help you learn new skills and offer you new and insightful market perspectives.

Be honest with yourself. It takes a lot of time and efforts to properly prepare for the trading day/week. If you have a full-time job outside of trading, time is an extremely valuable resource. Becoming a fully independent trader and idea generation machine can be your ultimate goal, but to get there faster you can use the help of an outside mentor – someone who can share good trading ideas, teach you how to approach financial markets and manage risk.

As Christian Siva-Jothy says in “Inside the House of Money” – “ No one gets paid for originality. You get paid for making money. I am happy to take other people’s good ideas and run with them, as long as I understand why I am in a trade.”

4. Take the occasional mental breaks from trading. Trading could be very emotionally draining. Find a balance between work and life. Have a hobby outside of trading to occupy your mind. Trading can be a joyful and a profitable experience. If it is not, you are doing it wrong and you need to look for some help.

5. Take care of your health – physical, mental, and emotional. Your trading results depend on your overall well-being. Eat healthy, move a lot, sleep as much as you need to, practice empathy, travel to new destinations to nourish your creativity. Regular 2-minute meditation per day may help to improve your focus and alleviate your anxiety. Do you know what is three times better than meditation for reducing stress? – laughing. Watching some stand-up comedy every day can boost your immune system and make a sharper thinker.

Check out my new book: Top 10 Trading Setups – How to find them, when to trade them, how to make money with them.

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Different Setups Work In Different Markets

“The market plays the music. How you dance depends on the music played.” – Brett Steenbarger

They say that the definition of insanity is doing the same things over and over again and expecting different results. If you do the same things over and over again in the stock market, you are guaranteed to get very different results. Do you know why? Because the market is constantly changing. This is the big secret of financial markets. Nothing works all the time.

Different setups work in different markets. Everyone makes money in a bull market. Not everyone keeps it when the market goes into correction or a range-bound, choppy mode. A good trader is able to adapt to changing markets. Many get into trading with dreams of getting rich quickly and becoming financially independent. The problem is that most expect things to happen immediately. At the beginning of their career, most people are undercapitalized and have no idea what they are doing. When you are undercapitalized, you are likely to do at least one of the following five major mistakes: • trade too big, • trade without an edge or in other words – gamble, • overtrade, • trade low-priced junk stocks, • use excessive leverage.

Some say that discipline and risk management are the solutions to all trading challenges, but they are not going to help you if you trade a setup without an edge in the current market.

Discipline + A losing setup = Consistent losses and frustration.

The one big thing that can improve your trading life is learning how to recognize changes in markets and being able to quickly adapt to them. Different setups work in different markets. Knowing what works and what doesn’t work in each environment is 80% of the battle. There are four major types of markets and each of them requires a different method: Uptrend, Range-bound, Downtrend, and Bottoming Process. On these pages, I share my approach to each of them. There are six main factors that have the biggest impact on stocks’ price action in a short-term perspective: • the general market direction, • price momentum, • industry momentum, • float and newness – is it a recent IPO, • market reaction to a recent earnings surprise, • and short interest.

In this book and in my personal trading, I focus on setups that have at least two of the above-mentioned catalysts going for them.

This is one of the most practical trading books ever written. It doesn’t waste your time with personal stories of grandeur. It is all about setups. I explain what setups to trade and when, why they work, how to find them, how to trade them, where to exit. It is a complete game plan for any market environment.

And since I believe a good picture is worth a thousand words, there are 140 annotated charts with examples for the ten major setups discussed in the book.

Here’s the table of contents for the book:

INTRODUCTION – The one thing that will make you a better trader.

Chapter 1. BREAKOUT SETUPS – How to profit from range expansion.

Chapter2. PULLBACK SETUPS – How to enter an established trend with low risk and for high reward.

Chapter 3. IPO SETUPS – How to find stocks that can go up 50% in a month.

Chapter 4. INDUSTRY MOMENTUM SETUPS – How to benefit from one of the most powerful market forces.

Chapter 5. EARNINGS GAP SETUPS – How to profit from post-earnings-announcement drift.

Chapter 6. SHORT SQUEEZE SETUPS – How high short interest might lead to explosive short-term moves.

Chapter 7. HUGE VOLUME SETUPS – How to quickly grow a small account.

Chapter 8. BEARISH SETUPS – How to make money during corrections.

Chapter 9. RELATIVE STRENGTH SETUPS – How to gain from the moves of big players.

Chapter 10. MEAN-REVERSION SETUPS – When is the right time to go against a trend.

Summary

It is available on Amazon.

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3 Major Takeaways from the Crash in 1987

October 19. 2016 marks 29 years since the so-called “Black Monday” when Dow Jones lost 22% in a single day. Coming into Black Monday, DJIA was already down 20% from its annual highs achieved in August and trading below its 200-day moving average. Paul Tudor Jones, who was one of the lucky guys to make a fortune in 1987 says that he used the 200-day MA as a sign get out and get short. He made 127% net of fees that year.

Not everyone was as fortunate as PTJ in 1987.

Stanley Druckenmiller lost a lot of money during the crash by trying to pick a market bottom.The Friday before the 1987 crash, Druckenmiller goes from net short to 130% long. Here is his conversation with Jack Schwager in The New Market Wizards’ book:

– You’ve repeatedly indicated that you give a great deal of weight to technical input. With the market in a virtual free-fall at the time, didn’t the technical perspective make you apprehensive about the trade?

– A number of technical indicators suggested that the market was oversold at that juncture. Moreover, I thought that the huge price base near the 2,200 level would provide extremely strong support— at least temporarily. I figured that even if I were dead wrong, the market would not go below the 2,200 level on Monday morning. My plan was to give the long position a half-hour on Monday morning and to get out if the market failed to bounce.

Another important lesson to be drawn from this interview is that if you make a mistake, respond immediately! Druckenmiller made the incredible error of shifting from short to 130 percent long on the very day before the massive October 19, 1987, stock crash, yet he finished the month with a net gain. How? When he realized he was dead wrong, he liquidated his entire long position during the first hour of trading on October 19 and actually went short. Had he been less open-minded, defending his original position when confronted with contrary evidence, or had he procrastinated to see if the market would recover, he would have suffered a tremendous loss. Instead, he actually made a small profit. The ability to accept unpleasant truths (i.e., market action or events counter to one’s position) and respond decisively and without hesitation is the mark of a great trader.

The infamous day trader, Marty Schwartz had a tough day on October 19, 1987, but he managed to cut his losses quickly:

I came in long. I have thought about it, and I would do the same thing again. Why? Because on October 16, the market fell 108 points, which, at the time, was the biggest one-day point decline in the history of the stock exchange. It looked climatic to me, and I thought that was a buying opportunity. The only problem was that it was a Friday. Usually, a down Friday is followed by a down Monday.

The high in the S&P on Monday was 269. I liquidated my long position at 267.5. I was real proud of that because it is very hard to pull the trigger on a loser. I just dumped everything. I think I was long 40 contracts coming into that day, and I lost $315,000.

One of the most suicidal things you can do in trading is to keep adding to a losing position. Had I done that, I could have lost $5 million that day. It was painful, and I was bleeding, but I honored my risk points and bit the bullet.

I thought about going short, but I said to myself, “Now is not the time to worry about making money; it is the time to worry about keeping what you have made.” Whenever there is a really tough period, I try to play defense, defense, defense. I believe in protecting what you have.

Looking at the charts above, I have a few main takeaways from 1987.

1.  Crashes in stock indexes rarely happen when they are near their 52-week highs. They happen below 200-day moving averages.

2) The tape gave plenty of warning signs to decrease substantially your equity exposure. SPX made lower low below its 50dma a week before the event. People had plenty of time to raise cash or hedge their long-term long positions.

3) Any quick pullbacks of 20% or more in the general stock market are usually a good buying opportunity for long-term investors. The market took its sweet time to recover from that flash crash and I am sure that buying the right stocks made a big difference in returns.

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The Consequences of a Booming Passive Investing

WSJ is out with a post calling stock picking a “dying business”. And the facts are on the Journal’s side:

Over the three years ended Aug. 31, investors added nearly $1.3 trillion to passive mutual funds and their brethren—passive exchange-traded funds—while draining more than a quarter trillion from active funds

What’s more interesting to me are the potential consequences of this rising passive investing tsunami:

1.The more money flows to passive investing, the faster markets are likely to become. This will lead higher correlations among stocks and more volatility, which means bigger and quicker corrections; it also means bigger and quicker recoveries. Take a look at the bear market of 2000-2002. As harsh as it was, there were plenty of stocks the kept making new all-time highs during that period and delivered some real alpha. Then, compare it to the correction in 2008, 2011, even early 2016. We saw a lot higher correlations during the most recent corrections. Most stocks went down together; then, they recovered together. Is it a big surprise then if leveraged ETFs are becoming the weapon of choice of more and more active traders?

2. More opportunities for savvy stock pickers. A rising wave lifts all boats, including the crappy ones, creating multiple great short targets. A swift correction will bring down strong businesses to super-attractive valuations.

3. A decrease in hedge funds’ fees. 1 & 10 might become the new 2 & 20. If you find a great money manager, 2 & 20 is a small price to pay, but the majority of investors are likely to demand and try to negotiate lower fees. This will likely lead to an increase in actively-managed ETFs. Most of them will be crap and will underperform after fees.

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Five Market Insights from George Soros

George Soros is a living legend among traders. With a net worth of $28 Billion, he is the richest market speculator in the world, after Buffett. What’s interesting is that he started his hedge fund when he was 42 years old. His proteges share that his batting average is terrible. They say he has been right about 30% of the time, but when he is right, he’s right and he makes sure to fully capitalize on it. His trading philosophy could be best described with two phrases:

“It doesn’t matter if you are right or wrong, but how much money you make when you are right, and how much money you lose when you are wrong”

“When you have a tremendous conviction on a trade, you have to go for the jugular. When you are right on something, you can’t own enough”.

Here are a few more tidbits that reveal how Soros thinks about financial markets:

Perceptions affect prices and prices affect perceptions

I believe that market prices are always wrong in the sense that they present a biased view of the future. But distortion works in both directions: not only do market participants operate with a bias, but their bias can also influence the course of events.

For instance, the stock market is generally believed to anticipate recessions, it would be more correct to say that it can help to precipitate them. Thus I replace the assertion that markets are always right with two others: I) Markets are always biased in one direction or another; II) Markets can influence the events that they anticipate.

As long as the bias is self-reinforcing, expectations rise even faster than stock prices.

Nowhere is the role of expectations more clearly visible than in financial markets. Buy and sell decisions are based on expectations about future prices, and future prices, in turn are contingent on present buy and sell decisions.

On Reflexivity

Fundamental analysis seeks to establish how underlying values are reflected in stock prices, whereas the theory of reflexivity shows how stock prices can influence underlying values. One provides a static picture, the other a dynamic one.

Financial markets do not play a purely passive role; they can also affect the so-called fundamentals they are supposed to reflect. These two functions, that financial markets perform, work in opposite directions. In the passive or cognitive function, the fundamentals are supposed to determine market prices. In the active or manipulative function market, prices find ways of influencing the fundamentals. When both functions operate at the same time, they interfere with each other. The supposedly independent variable of one function is the dependent variable of the other, so that neither function has a truly independent variable. As a result, neither market prices nor the underlying reality is fully determined. Both suffer from an element of uncertainty that cannot be quantified.

On bubbles

When I see a bubble forming, I rush in to buy, adding fuel to the fire. That is not irrational.

Boom-bust processes are asymmetric in shape: a long, gradually accelerating boom is followed by a short and sharp bust. The bust is short and steep because it involves the forced liquidation of unsound positions.

First, financial markets, far from accurately reflecting all the available knowledge, always provide a distorted view of reality. The degree of distortion may vary from time to time. Sometimes it’s quite insignificant, at other times, it is quite pronounced. When there is a significant divergence between market prices and the underlying reality, there is a lack of equilibrium conditions.

I have developed a rudimentary theory of bubbles along these lines. Every bubble has two components: an underlying trend that prevails in reality and a misconception relating to that trend. When a positive feedback develops between the trend and the misconception, a boom-bust process is set in motion. The process is liable to be tested by negative feedback along the way, and if it is strong enough to survive these tests, both the trend and the misconception will be reinforced. Eventually, market expectations become so far removed from reality that people are forced to recognize that a misconception is involved. A twilight period ensues during which doubts grow and more and more people lose faith, but the prevailing trend is sustained by inertia.As Chuck Prince, former head of Citigroup, said, ‘As long as the music is playing, you’ve got to get up and dance. We are still dancing.’ Eventually, a tipping point is reached when the trend is reversed; it then becomes self-reinforcing in the opposite direction.

On trend following

Once a trend is established it tends to persist and to run its full course.

Currency movements tend to overshoot because of trend-following speculation, and we can observe similar trend-following behaviour in stock, commodity and real estate markets, of which Dutch Tulip Mania was the prototype.

When a long-term trend loses its momentum, short-term volatility tends to rise. It is easy to see why that should be so: the trend-following crowd is disoriented.

Markets might be forward-looking, but they are not always right

How good are markets at predicting real-world developments? Reading the record, it is striking how many calamities that I anticipated did not in fact materialise.

Financial markets constantly anticipate events, both on the positive and on the negative side, which fail to materialise exactly because they have been anticipated.

It is an old joke that the stock market has predicted seven of the last two recessions. Markets are often wrong.

It doesn’t hurt you what you don’t know, but what you think you know, when it ain’t so

Participants act not on the basis of their best interests but on their perception of their best interests, and the two are not identical.

On Manipulation

I want to buy $300 million of bonds, so start by selling $50 million. I want to see what the market feels like first.

On how to be selectively active

The trouble with you, Byron [Byron Wein – Morgan Stanley], is that you go to work every day [and think] you should do something. I don’t, I only go to work on the days that make sense to go to work. And I really do something on that day. But you go to work and you do something every day and you don’t realise when it’s a special day.

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A Few Recent IPOs that I am Watching

The IPO market is gradually coming back. After the huge runups in ACIA and TWLO, more companies are eager to go public. Probably, we are not too far from seeing a really big fish filing for an IPO – Snapchat or Uber.

Based on current price action, the market is eager for new IPOs. Taking into account that all new companies offer only 10 to 20% of their float and thousands of funds compete to own a limited number of shares, it is not a big surprise that IPOs are a favorite trading vehicle for many traders.

Here are a few names that I am watching: NTNX, COTV, NH, PI, TPIC, LN, PTI, YRD, AVXS, AIRG, FLGT, etc.

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The 9 Hottest IPOs of the Past Year

The IPO pond has dried out in the past year, but it has remained an incredible source of trading ideas. Due to their small float and newness, some new public companies tend to significantly outperform during rising markets and significantly underperform during market corrections.

Here’s a list of the nine hottest new stocks for the past year. Many have already had their run and are due for a pullback. Others are setting up again.

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A Good Trader Should Be Able to Adjust to Changing Markets

A good trader should be able to adjust to changing markets. 2 to 20-day swing trades work beautifully in steadily rising markets. We experienced those for the most part from February to August 2016. Intraday trades are the real money makers during corrective markets. Volatility spikes during corrections and when volatility spike, three things usually happen:

1) Stocks trade in much wider daily ranges than usual. The intra-day moves are humongous and there’s plenty of liquidity behind them. Upside and downside moves that used to take 5-10 days are taking 2-3 hours during corrective markets.

2) There are many reversals. Many breakouts and breakdowns fail. Stocks gap up one day and then gap down the next. Such environment makes 2-20-day swing trades more challenging. Even if you trade in the direction of the general market’s trend (which is obviously down during corrections), you will have to go through numerous high-magnitude squeezes until you get paid properly. The only way not to get shaken out from normal price reactions is to use a very wide stop and a smaller position size.

3) Correlations between stocks and different asset classes rise as well. This means that stocks bounce and dive together regardless of individual company’s merits.

Speaking of rising correlations, what makes a strong impression in the current market pullback is how many stocks are holding extremely well and don’t pay attention to what the indexes are doing:

Small-cap biotechs, many of which don’t have any earnings or revenue, continue to break out and gain ground. In a typical market correction, those are among the hardest hit stocks.

Chinese ADRs, which are super volatile in general, continue to show relative strength. Again, this is usually among the most pressured group during corrections. Not this time.

Quite a few high-beta, momentum stocks are holding well, as well. A quick look at my SL50 momentum list shows numerous breakouts this week – GIMO, ANET, LOGM, FNSR, ZLTQ, etc. Those types of stocks tend to underperform during corrections.

All of the above makes me consider the current correction just a 5-8% garden variety pullback within a bull market. Maybe, it is too early to judge and fear will accelerate when prices go lower. No one really knows. Just thinking out loud and sharing a few observations.

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There Are Two Types of Corrections

There are two major types of corrections:

1. A normal pullback within a bull market – this is a garden-variety 5-8% pullback above a rising 200-day moving average. Momentum stocks with the highest relative strength during the correction are likely to significantly outperform during a recovery.

2. Deeper 15% to 20% correction in a major index – this one characterizes with periods of massive forced liquidation when people and institutions sell not because they want to, but because they have to. These type of corrections often start below a flat or declining 200-day moving averages of a major index. Some of these corrections turn into bear markets, which last more than a year. The best performers during a recovery are usually the ones that were hit the hardest during the correction – the ones that are down >80% from their 52-week highs, the ones that were essentially priced for a bankruptcy, but managed to survive.

Based on the current price action, I believe we are in the first kind of correction. Act accordingly.

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3 Scenarios for the Stock Market

The selloff last Friday brought back some volatility into the market. So far today, we are seeing a pretty strong bounce, but not impressive enough to change the overall technical picture. There are three main scenarios for the stock market in the next few weeks, listed in terms of probability:

1. SPY and QQQ enter into a wide, choppy range. Breakouts won’t work as well in this environment compared to the last 2-3 months. Mean-reversion trades will have an improved likelihood of success.

2. After a brief consolidation below their 50-day moving average, SPY and QQQ continue lower and test 210 and 110 respectively. Short-term volatility futures could go in backwardation under this scenario.

3. Quick V-shaped recovery to new all-time highs. This seems the least likely, but it is good to have an open mind and more importantly keep a watchlist with stocks that have held well during this minor pullbacks. Those stocks are the new leaders.

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Something to Ponder – AMD is up 165% YTD. Intel is Flat

2016 continues to be the year of big comebacks in neglected stocks. The geese have turned into swans.