Dealing With A Difficult Market

Let’s face it. More people than you hear and read about are having trouble in this difficult market environment. Profits were abundant for many risk takers from mid-2020 through 2021, whether you were a newly minted super-growth stock trader, discovered ground-breaking crypto schemes, or specialized in trading the big indices. But by now, you could call lucky the ones, who have only given back all those profits — not to mention those countless account blow-ups left by the wayside.

On average all efforts over the last two years have come to nothing for retail traders; Hawkeye Analytics

It is not immediately obvious why that should be the case, because flexible traders in theory have the opportunity to profit from any outsized move — up or down — and of those there were plenty recently. I think, the greatest difficulty is identifying and quickly reacting to a change in the market environment when deeply ingrained, profitable trade setups suddenly produce outsized losses (for example a simple S&P 500 or NASDAQ buy-the-dip approach).

Especially unhelpful is the widespread trading advice that volatile markets are the lifeblood for real traders to make great profits. While that may be true for some exceptional individuals, for me, unfortunately, that story has never been anything but a fairy tale. Due to systematic warning signals, I went to cash in all of my portfolios last week, which is a rare event that only happens every couple of years. I want to take advantage of this trading pause to take a step back and look at the bigger picture across my trading and investment portfolios. This is a personal process that I try to go through every couple of months, and I encourage you to do the same with your own portfolio, as each trader’s approach is highly idiosyncratic.

The key big-picture question I analyze is this: are there predictable patterns in the distribution of trading profits and losses? In other words, when do the biggest drawdowns occur and when are the biggest profits to be made? Of course, there will always be losses, but maybe there is a way to better control the size of these losses and to identify periods when the risk for outsized losses — and vice versa — is greatest.

In essence, I pose the question: What type of trader am I, and how can I use this insight to improve?

The answer for me personally is twofold: (1) listen closely to market regime indicators to identify favorable and risky periods; and (2) religiously rebalance a holistic portfolio between an investment part and a trading allocation. I wrote about rebalancing in detail last year (in this unlocked weekly report) during a period of windfall profits — it is an important mechanism that ensures that profits are secured and any change in the market environment has a smaller impact.

Meta Strategy Signals

A couple of years ago, I developed a model that guides my investment approach. I called it the Meta Strategy long before Facebook changed its name, and it incorporates technical warning and stop loss triggers based on market volatility and long-term trend among other indicators. I also use these triggers as regime change indicators, which has proven to be immensely helpful for my trading portfolio. (You can read about the Meta Strategy in detail in this free Ebook.)

Looking at my profits and losses (P&L) over the years, I see that my deepest trading account drawdowns happen, almost without fail, during periods after Meta Strategy warnings had already triggered. (The last clear volatility and trend warnings occurred at the end of February 2022 and again last week, in the beginning of May.)

But why is that so?

My go-to volatility warning signal is an inversion of the VIX futures term structure — it tells me that something is not right in the market;
The term structure on May 9th, 2022 via Vixcentral

It turns out that much of the trading lore concerning volatile market periods is extremely counterproductive to my own approach to the markets. In fact, I have come to the conclusion that the opposite is true for me, and that might just be true for you, too!

Common trading advice in many popular books and in the success stories of master traders often is as follows: In a volatile market one has to pounce, as large profits are being made. It is not the time to cower under your desk!
But that is not necessarily great advice for everyone.

Analyzing my own P&L, I have found the exact opposite pattern: When the market is in a calm uptrend it tends to be quite predictable and profits come easily — this is the time to pounce. Conversely, it is very common to see months of profits go up in smoke in a difficult market full off wide swings and violent reversals over all time-frames — just as the one we are in right now. That’s the time for me to scale down decisively or, better still, to simply take a break until the storm has calmed and this inherently less predictable phase has passed.

This is not a new insight for me, but one that has been strengthened by each new volatile market period over the past decades. The real difficulty is to implement it and make a decisive switch from risk-on to risk-off and back, because one gets used to simple strategies to seemingly always work. The process of adjusting that mental model to a new environment is often too sluggish — it is much harder than it sounds to just stop trading after an active, successful period.

I cannot stress this enough: those Meta Strategy warning signals are pure gold for my trading approach, because they enable me to preserve profits, as well as trade confidently with leverage in the right market environment to make those profits in the first place.

I have found the best time to batten down the hatches is during a relief rally, which occurs with high reliability after volatility and trend warnings were triggered in an above-average, sudden market drop. For some time market participants remain conditioned to buy the dip before the bottom falls out. In hindsight, this would in most instances have led to a trading sabbatical with a comfortably profitable final trade under my belt, before the real difficulties even began.

Unfortunately, in reality most of the time a jarring loss was necessary to serve as my wake-up call — in the end we can’t easily avoid being conditioned to the same biases as all the other traders! But we can always try to improve…

Good luck with your trading, and thank you for reading!

David