One of my close friends is a psychologist. She teaches me about conditions in general terms.
For example, she’s taught me that depressed clients can be slow to act. They know they need to do something — but they wait. When they finally decide to act, it can be impulsive.
This delayed and rash behavior plays out in the market too. After all, it is driven by human emotions.
I’ve witnessed plenty of episodes of depressed traders in market history. Their actions create important tops and bottoms.
Psychology is the force behind the price action we see. And it helps explain why market tops are so slow to form — and why bottoms hit quickly.
I’ll show you exactly why that is… and then I’ll share a useful timing tool that lets you know exactly when to buy after the bottom hits so that you won’t miss out on 30% of the new bull market…
Slow to Top, Fast to Bottom
At market tops, traders don’t want to believe a bear market is coming. They watch the market action, hoping for a rally. This is why tops often take weeks or months to form. Depressed traders see small losses and freeze.
Eventually, they will make the decision to sell. But this comes after losses have already mounted. That’s why bear markets are quick. They’re generally over in a few months.
Depressed traders can also be obsessive about the market. You see, after the pain of big losses, they will be desperate to get back to even. So, they will buy quickly when they see a bottom.
This behavior shows up in a chart. Take a look at the one below, showing the SPDR S&P 500 ETF (SPY) in the 2020 bear market. I added a 200-day moving average (MA) (blue line) to the chart.
(Click here to view larger image.)
As you can see, prices stopped rising in January. They moved in a narrow range for weeks. This is when depression was setting in.
Sell signals occur when the price falls below the 200-day MA. The initial sell signal in February was quickly reversed. A second sell signal avoided most of the bear market.
Let’s say you sold about 12% from the high with the MA. Not bad.
But the buy signal came after a 37% rally. That’s a little too late.
Unlike the top, traders rushed into stocks at the bottom. That created the new bull market. We saw a similar pattern in 2002 and 2009. Bottoms tend to be quick as traders turn manic.
Now, I don’t intend for my description of depressed traders to be insensitive. I’m trying to highlight a critical point here that tops are slow and bottoms are quick. This makes them challenging to trade.
Of course, I don’t want to just make a point. I want to offer a solution to the challenge…
Timing It Right in a Manic Market
To get better trade signals around tops and bottoms, I suggest using different indicators for buying and selling. That makes sense since traders feel different emotions when they’re trying to get in or out of the market.
Now, to improve your buy signals, consider using a shorter MA like the 20-day. The next chart adds a 20-day MA (green line).
(Click here to view larger image.)
This time, the indicator triggered a buy signal that’s much closer to the market bottom. You would have bought after a 17% rally, a substantially better entry than with the 200-day MA.
And the sell signal for the 20-day MA was also much closer to the top. You could have sold about 4.3% from the high.
The 20-day MA could work better for you to trade more frequently. That’s because it’s a more active indicator. It triggers more trades, most of them resulting in small losses.
If you have time to trade an active indicator like the 20-day MA, you should consider other powerful timing tools as well.Greed Gauge. I have my volatility indicator. Andrew Keene follows unusual options activity. There are countless others.Mike Carr has his
Now, if you don’t have as much time, the 200-day MA is still a decent bear market indicator. It will get you out shortly after the bear market begins.
But once you’re out, switch to a short-term timing tool such as the 20-day MA I described here to find a new entry. That way, you won’t miss the first 30% of the new bull market.
Amber Hestla Senior Analyst, True Options Masters