Trading Tips During a Correction
Key Coronavirus Updates:
- The estimated number of global coronavirus infections has risen to more than 17,000 with at least 360 associated fatalities
- The first death outside of China linked to the novel coronavirus was reported in the Philippines
- On Jan. 30, the World Health Organization (WHO) declared the novel coronavirus outbreak a global health emergency
- On Jan. 31, the U.S. Secretary of Health and Human Services declared the novel coronavirus outbreak a public health emergency in the United States
- Gilead Sciences (GILD) announced that it has supplied an experimental antiviral to a small number of patients infected with the novel coronavirus. A patient in Seattle already treated with the antiviral saw almost all symptoms resolved (except a cough, which did improve)
- More than 10,000 flights have now been cancelled as a result of the epidemic
- Apple (AAPL) announced it is closing all 42 of its stores in mainland China, which together account for roughly 1/6 of the company’s total sales
- China’s Bidu Inc. (BIDU) is delaying its fourth quarter earnings announcement and has advised employees to work from home
- Starbucks (SBUX) closed roughly half of its 4,300 stores in China and expects a material—but temporary—effect on its 2020 financial forecasts
The stock market in the United States has been rallying for so long that many traders in today’s market have likely never witnessed a systematic crash.
That could all change soon, depending on how the current coronavirus epidemic plays out.
And even if the financial markets manage to dodge the correction bullet during this outbreak, it’s 100% certain that a serious market correction will develop at some point in the future. That’s inevitable.
Because of this, every investor and trader should have a plan of action that can be deployed at a moment’s notice during corrective periods. And an effective plan such as this ultimately hinges on an understanding of the markets’ tendencies during corrections, which was the focus of a past installment of Options Jive on the tastytrade financial network.
One of the first signs that a correction may be occurring is not only the fact that asset prices are declining, but also that correlations between them are rising. In layman’s terms that means investors selling into weakness become less concerned about the “quality” of a given asset and instead simply sell “anything and everything” that has a bid.
Likewise, strategies (e.g. specific position structures) also become more correlated, meaning all short volatility strategies might lose, and all long volatility strategies might win. As opposed to a normal trading day, which might see winners and losers from both groups.
In a serious selloff, what often matters most is units. How many short contracts are in the portfolio versus long contracts? Similarly, the difference between “defined risk” and “undefined risk” positions also becomes clearly illustrated when uncertainty is peaking.
Defined risk positions are those in which the maximum losses are known prior to trade deployment, whereas undefined risk positions theoretically can be subject to “unlimited” losses. When financial markets start making jagged moves, it’s the latter type of positions that can keep traders awake at night.
The type of underlying security in one’s portfolio can also make a big difference when volatility is rising. Single stocks can go bankrupt, whereas indexes and ETFs typically do not. During times of heightened volatility, traders can limit risk by trading exclusively in indexes or ETFs to minimize unsystematic (i.e. stock specific) risks in their portfolio.
It’s for the above reasons that tastytrade often stresses the importance of keeping position sizes small and consistent at all times. This not only diversifies risk across the portfolio, but also allows traders to rebalance their portfolios quickly when necessary.
Maintaining discipline, trading within one’s unique risk profile and keeping a clear head—no matter the market environment—is always the best path toward bringing home consistent, positive returns.
To avoid outsized drawdowns during corrections, traders can follow some simple guidelines to reign in risk:
- Keep position sizing small and consistent
- Rebalance the portfolio regularly
- Diversify across asset classes
- Diversify across strategies
- Lean on “defined risk” positions to avoid catastrophic losses
- Remain disciplined and systematic in terms of decision-making
The next issue of Luckbox magazine is focused on China. Help us with our coverage by lending your thoughts on the China Threat, Trade policy & Trump. Your responses may be published in our next issue. Check out the current Luckbox Reader Survey here.
To read the previous post in this series click here. To learn more about what to expect during a market correction, traders may want to review the complete episode of Options Jive focusing on this topic when scheduling allows.
Sage Anderson is a pseudonym. The contributor has an extensive background in trading equity derivatives and managing volatility-based portfolios as a former prop trading firm employee. The contributor is not an employee of Luckbox, tastytrade or any affiliated companies. Readers can direct questions about topics covered in this blog post, or any other trading-related subject, to firstname.lastname@example.org.