Developing Strategies for Trading Stock

Categorizing the phases of the market enables you to adjust your trading strategies based on current market conditions. The idea: Trade aggressively when you're confident in your market assessment, but protect your capital when you're uncertain.

Trading the bullish transition

When you first decide the market may be entering a bullish transition phase, you need to use extreme caution when trading, because at this phase of the market your primary goal is preserving your capital. Your secondary goal is getting in on the bull market, if it materializes.

You may take new positions during a bullish transition, but the situation is not urgent, so you can be selective. You need to take small, partial positions rather than full positions by

  • Identifying the strongest stocks in the strongest sectors
  • Looking for trading-range breakouts and other reversal signals

Keep your stops very tight and honor them rigorously. Consider an exchange traded fund, which is similar to an index mutual fund but is traded on the stock exchanges, if you have difficulty finding individual stocks that meet your fundamental and technical criteria.

Trading in a bull market

In a bull market, your primary goal is to become fully invested. Your secondary goal is capital preservation. Emphasize establishing long positions in your trading. You shouldn't take on new short positions. Buy breakouts and take full positions, because your goal is to be 100 percent, or fully, invested. If you have a margin account for leverage, now is the time to use it. You may loosen your stops a bit, because doing so allows for more ebb and flow of higher highs and higher lows.

The most reliable bull market signals occur during the early part of a bull market — after a bullish transition rather than following a bullish pullback. You may want to adjust your strategy to be a bit less aggressive following later-stage bull market signals. For example, you may want to tighten your stops a bit, especially when you're using margin for leverage.

Trading the bullish pullback

A bullish pullback is a consolidation phase within a bull market in which your trading strategy needs to continue looking for high quality stocks that are breaking out of new or subsequent trading range bases. When you decide the market has entered a bullish pullback phase, you may want to tighten your stops and seriously consider hedging your positions by using options, especially when you're using margin for leverage. Hedging is like buying insurance. In this case, put options can be purchased to protect most of your trading capital in case the market moves dramatically against you.

A bullish pullback still is a bull market, so you can continue taking full positions on breakouts, but you need to be selective. Make sure that your new and existing positions are the best performing stocks in the best performing sectors. You need to become a bit more cautious when the particular bullish pullback isn't the first to occur during the current bull market.

Trading the bearish transition

A bearish transition indicates the market may be transitioning from a bull market to a bear market. You react to a bearish transition by

  • Tightening stops on all your open positions
  • Monitoring your positions closely
  • Honoring your stops rigorously
  • Exiting any long position at the first sign of trouble

You also need to consider hedging long positions by using options. If you're using margin for leverage, exiting failing positions quickly is even more important.

If you are so inclined, you can begin looking for short sale candidates, but only nibble at these trades. If you plan to short, take small positions and keep your stops very tight.

Trading in a bear market

When you're certain a bear market has begun, don't enter new long positions. Your open positions are likely to hit their stops and be closed, but for the ones that remain, tighten your stops and exit any existing long positions at the first sign of trouble. Hedge any remaining long positions with put options.

If you're inclined to short stocks, a confirmed bear market is the time to do it. You may want to take full-sized short positions and become fully invested on the short side. Note: A margin account is required for selling short. We rarely use margin for leverage when trading short, but if you're going to do it, now is the time.

Trading the bearish pullback

A bearish pullback is a consolidation phase within a market that nevertheless remains a bear market. As such, a bearish pullback is not a good opportunity for taking new long positions. You need to tighten stops on existing short positions, and consider hedging these positions using call options, especially when you're using margin for leverage. A bearish pullback is an opportunity to take short-side profits and enter additional short positions when you see new or subsequent downside breakout patterns. Confirm that new and existing short positions are the worst performing stocks in the worst performing sectors.

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