Saturday, March 14, 2009

Catching a Falling Knife?

Trying to pick a bottom on a falling stock or index can be a very difficult proposition and, in the trading business, has been likened to trying to catch a falling knife. Last Tuesday, when the Dow rocketed up almost 380 points, there was a lot of excitement and speculation about whether we had finally seen a bottom. Much of that particular move was evidently sparked by an announcement that Citigroup (C) had made a profit for the first two months of the year. The fact that a company has made a profit, particularly after major government intervention, is great, but one has to wonder whether it is earth shaking news. Often, the markets exhibit a tendency to overreact to a news event and though the news was certainly a positive in a market that has been filled with negatives one has to wonder whether the big spike was an overreaction or the start of a reversal.

In my individual coaching sessions, I always suggest that my students try to trade in the direction that gives them an edge. If the market, sector, and stock are all going down, for example, why take a long position? Who or what is to say that it is going to turn up and even if we say it is going to turn up, the question becomes when will it do that? Couldn't the stock just keep going down? Recent history has, once again, taught us that zero is truly a level to which some equities can descend.

While it may be very tempting to jump on board when prices are at such low levels as they have been lately (e.g. GM at $1.50, GE under $8), we need to remember that there is still room below. When markets, sectors and stocks are bearish, my view is that it is best to make bearish plays or simply stand aside. Wait for the actual bullish turn rather than trying to predict. As I suggested in a recent article, no one can predict with certainty. If we think we can, we just need ask ourselves what will the news be tomorrow.

The Dow has been in a downtrend since the latter part of 2007 and it will remain in that downtrend unless and until it breaks up through the downtrend line. The same is true for the Nasdaq Composite and the S&P 500. That is not to say that there cannot be rallies in a bear market, but they are exactly that -- bear market rallies. They are to be expected, but it remains important that we understand the difference between a rally within a bear market and a break in the downtrend that actually can signal a return to the bull. Otherwise, we may find ourselves trying to catch that falling knife (or piano).

by Bill Kraft, Editor
Copyright 2009, Makin' Hay, Inc.
All Rights Reserved

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To comment on Bill's article click on the "comments" link below.


Manish Chauhan said...


That was good . I have often and till now tried to take positions against the trend and in long run its ruining me .

What to tell ourself when there is so much tempt to buy at the lowest level and make a killing .


Anonymous said...

Study the "counting method" to learn when a market bottom has been reached. Very specific indicators involved to sigal reversal patterns, with over 90% accuracy. Your information is much to "general" to be of much use for traders. Everyone knows we are in a volatile market which requires caution.

Anonymous said...

In case any of your readers are interested in the best method to determine a market bottom, Here it is, FREE of charge, no expensive schooling, seminars, or rediculous fees needed!

Here’s a price pattern to determine if indeed we’ve just experienced a market bottom, meaning the market has just gone through an honest to goodness trend reversal and a bear trend has indeed turned into a bull trend…

1. Look for an up day when the existing trend has been down.

2. The lowest point in intraday trading of the first rally day becomes a support line.

3. The next two days of trading must both stay above the support line of the first day.

4. On the fourth, fifth, sixth or seventh day (fourth is better than seventh), look for the price close of the day to be above the price close of the previous day, volume of the day to be greater than volume of the previous day (the heavier the better) and above average, and the increase in price of the day represents 1% or more of the index being studied. This day is called the “follow-through” day.

5. We have to see this on “The Big Three” (Dow, NASDAQ, S&P500).

If the price movements conform with all of these “rules,” then it is highly likely the down trend has reversed to an up trend. In fact, this method is accurate anywhere from 80% to 97% of the time.

Have we reached a market bottom yet? Now you know!

boblink said...

Thank you for sharing your worthy knowledge. I believe that you are entirely correct. Is the only reliable uptrend support a longer term indicator like the 200 day moving average or is their some other sound early indicators for the major indices? Sorry, if I ask too much.

Anonymous said...

Dear Mr. Kraft:

What do you look for to distinguish a bear market rally from a reversal, and what would you do to determine your entry into a particular stock based on whether you think the trend will be short (as in a bear market rally) or long ( as in a multi-year trend)? Thank you. E. Stein

Anonymous said...

I studie for almost 6 years the moving averages in multiple time frames. There is always a relationship between the 5 ma and the 20 ma in every timeframe.
We all know that the bigger timeframes overrulles the smaller ones. So, when we look to the monthlys we can see that the 5 ma crossed the 20 ma to the downsite, so the bottom could be zero indeed.
Of course when we look to the daily or weekly we see a possible move to the north but only because of extention and still in a downtrend on the monthly. The charts of de ndx monthly are a good example to learn not to fight the position between the 5 ma and the 20 ma.

Bill Kraft, said...

Thanks for writing, Manish. Contrary to some of the suggestions of some of the bloggers this week, bottoms are difficult if not impossible to pick with certainty. I would suggest that successful traders are more likely to trade direction after the direction has been clearly established. As you say, taking positions opposite a trend can definitely be ruinous.
Bill Kraft

Bill Kraft, said...

Sorry the information was too general for you Anonymous. I'm curious to know whether you consider the "counting method" to be infallible.
Bill Kraft

Bill Kraft, said...

Thanks for the contribution, Anonymous. As I understand your 4 rules, you have pronounced that we are now out of the bear market and have seen the bottom. I join with America in hoping you are correct. I would personally still like to see a break up through the downtrend since it remains a downtrend until that occurs and so far it has not occurred so I would still urge caution.
Bill Kraft

Bill Kraft, said...

Thanks for writing E Stein. I see the reversal to a bull market only when the long term down trend line has been broken. I have to say I never try to predict whether a move will be short or long since there is no way I know to make that prediction with any assurance of accuracy whatsoever. Instead, I try to take what the market will give me by (for example) using a trend for an exit. Whether a rally is only a bear market rally, or a new bull market, for example, when I see an upward move begin as it did last week for example, I am willing to take bullish positions provided I have an exit based on a break back below the new uptrend (rally) line. Similarly, if the market is moving down as it has been, I'll try to take bearish positions with an exit based on a deviation in the opposite direction. I personally believe it is futile to try to predict how long a directional movement will last. As some suggest, we could now be starting a new bull market, but that could change in a fraction of a second with a dramatic change in world events. Hope that gives some clarity.
Bill Kraft

Bill Kraft, said...

Thank you for writing, boblink. I would suggest you read my response on the blog to E Stein. In one sense, any downtrend remains in effect until the downtrend line is broken by a move up through it. I have been discussing a line drawn down from the tops back in 2007 for the Dow and 2008 for the Nasdaq Composite. Using a 200 day moving average or a 26 week moving average (or almost any moving average) is another way to measure a down trend and when broken can signify a reversal. Much is dependent on the trader's personal time frame and at least part of the discussion is somewhat academic. When I identify a trend, whether it be up or down, long or short, I try to take positions that will benefit from the move and I try to make the directional plays in the direction of the currently existing trend. More than one trend can exist at the same time. For example, we are currently in a long term down trend, but last week saw at least the beginning of an uptrend. So far that uptrend has been short, but it is impossible to say when it will be broken; we can only say it will be broken when the new uptrend line is pierced. Hope that helps.
Bill Kraft

Bill Kraft, said...

Thank you for writing, Milalo. I also watch moving averages and moving average crossovers though I've never specifically focused on the 5 and 20. I have used the 20 quite a lot.
Bill Kraft

Anonymous said...

Thanks for your clarification. What do you consider long term trend line? Are you looking at the 200 day moving average? Sorry to keep pestering you with this!
E. Stein

Anonymous said...

oh, never mind, I see that is what you wrote in response to Boblink- 200 day moving average or 26 week moving average. I understand, thanks again E. Stein

Anonymous said...

Since Friday the 13th of March'09, the trend has been up, and, thinking that it "should be" going down I held some short positions overnight for most of the following week. Thats when I lost a lot of money, by having short positions in this bear market rally. Ironic. So I don't see the value of what you are trying to say in your 'falling knife' article.

Bill Kraft, said...

Anonymous, thank you for writing. In the "falling knife" article, I wanted to promote awareness that predicting bottoms and trading against market direction can be dangerous. That doesn't mean that a trader should not have a strategy to exit when reversals inevitably occur. If you have been reading my articles for the past several years, you know that I have long advocated an exit strategy that is developed BEFORE we ever enter a position. If a trader has bearish positions in a bearish market, he is trading the direction of the market and often giving himself an edge. That does not mean he should do so without exits (e.g. stops) that will take him out of bearish positions when the market reverses whether the reversal is a bear market rally or a return to bullishness. Cutting losses (and every trader will have losses) is a critically important function for every trader. I believe traders and investors should always have an exit strategy no matter what market direction they are playing.
Bill Kraft