The Importance of Setting Trading Limits

The Importance of Setting Trading Limits

On Social Media, many of our recent posts and predictions have been questioned.  There is doubt that an asset bubble, or series of them, is forming.  Most analysts still believe that interest rates will be unchanged.  In contrast, we recently made a case for the potential of an immediate CUT and resumption of Quantitative Easing. “Federal Reserve Stokes Another Asset Bubble”. (https://markonomics101.com/2019/03/22/federal-reserve-stokes-another-asset-bubble/).

Former Federal Reserve Chairman, Janet Yellen, is now calling for a fortified “Fed Put”.  The Fed Put is the phrase used to describe the use of monetary stimulus to mitigate market losses for investors.  This policy keeps markets overvalued because investors take it to mean that their risk is greatly reduced and gives a green light to pure speculation.  In other words, it creates Bubbles.  (https://www.zerohedge.com/news/2019-03-27/janet-yellen-suggests-strengthening-fed-put).

The idea of new highs in the major indexes, such as Dow 30K, has been met with doubt.  Dow 30K? Yes, but”.  (https://markonomics101.com/2019/03/04/dow-30k-yes-but/).

Trading Limits Prevent Big Mistakes

But what if these doubts are well founded and we’re wrong?  Believe it or not, it DOES happen.  Nothing is guaranteed.  Successful trading must include a game plan in advance.  The game plan is to determine preset levels at which one would enter a trade, and also exit a trade, if it becomes adverse.

The absolute BIGGEST and most deadly mistake a trader could make is to be stubborn.  This is common among traders who absolutely HATE to admit they’re wrong.  If you want success, rule number one is to leave your ego at the door.  If it appears you’re wrong, the best course is to cut losses quickly and AVOID THE BIG HIT.  There is no shame in being wrong.  The shame is in STAYING WRONG.

Let’s take a look at the charts to come up with levels that make the most sense in the major indexes today, which would limit losses.

Forming the “BIG PICTURE”: The Dow Industrials

So, let’s formulate a game plan assuming we’re trading the Dow, which has an ETF (DIA).

We’ve noted on many occasions the reliability of the ROUNDED BOTTOM pattern, or its close variant, the CUP and HANDLE.

The Dow appears to be forming and concluding this usually bullish pattern.

Looking at the Cup and Handle, the level of 26,000 to 26,250 has held back rallies on 4 occasions. The Dow is now consolidating in the Handle, with support at 25,200.

A good entry point would be an upward break through 26,250.  A sensible sell stop would be the lower part of the Handle at 25,200. This would be less than a 5% loss.  More importantly, breaching support at 25,200, invalidates the “Cup and Handle”, making the trade a poor bet.

The Nasdaq 100 (NDX) might need a slightly different game plan.  The Nasdaq became a Buy above 7200. It traded up to 7500 but has retraced to 7300.  A sensible sell stop would be just below 7200, which is now support.  That would limit your loss to no more than 1 or 2%.

Upon breaking the 7200 support area, the NDX has exposure to AT LEAST 6600.  No reason to stay in the trade below 7100 or so.

Sometimes There Are Multiple Possible Game Plans

One could play the Russell 2000 in one of two ways.  First would be to buy now at 1522 and set the sell limit at 1460.  This would be based upon the bet 1600 will be exceeded, with a 4% loss limit, if the second support at 1460 is breached, triggering a Sell Signal.

The second would be to wait for a break of 1600 and use 1490 for a sell limit.  The maximum loss might be in the range of 8% or so.

The first trade has a better risk/return ratio than the second because a CUP and HANDLE pattern is highly likely to produce a positive outcome.  Buying closer to the low of the HANDLE is the ideal entry point especially when the sensible sell stop of 1460 is taken into account, plus the possible gain up to 1600 would be 5% with an upside breakout adding to the return likelihood.

A Few More Equity Indexes

Below is a slide show illustrating various entry points and logical sell stop zones.

This same type of game plan can be applied to individual stocks.  In addition, the equity indexes all have room to decline further without invalidating their BULLISH Cup and Handle patterns.  Another 2 or so percent drop would still be normal and expected in their patterns.

Keep in mind that these are still HIGHLY BULLISH patterns and, until breached, have a high likelihood of positive resolution. In all cases losses can be limited to less than 5% if Mr. Market has thrown us a curve.

Conventional Wisdom About The Recent Market Pullback

The torrid rally in Bonds is believed to be a signaling of a weaker economy and the rally in stocks, therefore, “being unwarranted”.  We suspect this explanation is not complete.  One has to consider the fact that $10 Trillion in Bonds on the world market have negative yields.  Central Banks in Japan and Europe have “benchmark” rates that are negative.  Isn’t possible that US treasures, which yield almost 2.5% on the short end and nearly 2.9% on the long end, are perceived as being better values?

Or, maybe the “market” is starting to price in a rate CUT by the “anxious to please” Fed?  There is really no illogic in the rally in stocks.  As bonds yields fall, stocks are a better relative value.  The Utility index is well into NEW HIGH territory.  It trades on dividend yields.  It may be as simple as the competition for relative value between debt and equity.

In this overvalued environment, long run investment opportunities are limited but not absent.  The key is to be aware of what pieces of information are relevant and which are not.  Fundamentals, for example, are utterly useless.  Relying on them is of no value.  The charts contain all the information that is needed.  That’s our job to provide you with matters.

We hope you are benefitting from the insight and information we provide.  Why not join our mailing list?

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