Connors’ Weekly Battle Plan

This week I’m going to finish the profit taking lesson we started a few weeks
ago. I want us now to focus on locking in gains when markets reach overbought
and oversold conditions.

Let’s assume we are long a stock and we are short-term traders. We’ve all been
taught to “cut our losses short and let your profits run.” This advice is about
as useful as someone telling us to “buy low and sell high.” It’s pure
generalities and generalities are next to useless when you are making hundreds
of decisions a year in an effort to create profits.

But, let’s assume we do have “a specific, exact plan to cut losses.” This means
we know ahead of time exactly where our stops will be placed once we go long or
short any one position. And, let’s assume we are going to attempt to “let our
profits run.” If we are not stopped out, we need to lock in gains at some point.
And unless you are blessed with the clairvoyance of those analysts and
prognosticators who give you their price targets for where a stock will
magically go, you need to have a trigger to lock profits in.

Last week we looked at piecing out profits as they occur. Now we’ll look at
getting out of our remaining piece (or your entire piece if you hold a full
position), when the overall stock market tells us to.

It’s A Killer When They Reverse At Extremes

Some of the biggest swings in one’s account value occur when you are long (or
short) the market and it goes on a one-way tear. This happens a few times a year
and while the move is occurring in your favor, the gains most times tend to get
bigger and bigger. But, as the market becomes more overbought (or oversold) it
is not only giving you great gains, it is also putting you at maximum risk
for a drawdown (meaning losses off your peak equity highs). Why are you at
risk? Because this is when the biggest reversals happen. They happen after the
market moves strongly in one direction, adding more and more participants, until
there is no one left to buy. And then the selling occurs, and it occurs hard. On
the other side, when you are short and the market plunges, the risks of loss
from reversals are even higher because the bounces from oversold conditions tend
to be sharper than the sell-offs at tops (I’m talking about weekly/monthly
extremes, not multi-year extremes like we saw in 1987 and 2000).

So, how do you take advantage of this knowledge and apply it to your trading?
You become more aggressive in locking in your profits the more the market
becomes overbought and oversold. As I mentioned two weeks ago, the downside
is you miss the few times a year where the market moves even further. But, you
usually only miss a few days of this and it many times is given back very
quickly.

Your Nightly Routine

Here’s a routine you can follow nightly that will act as this compass for years
to come. Look at a basket of timing indicators. Look at the VIX (it’s the best
indicator in my opinion), advancing/declining issues, and the TRIN. Look at them
over a 10-day period and look if they are reaching extremes today. If all three
are saying the same thing, you have a pretty good idea how aggressive to be in
locking in your gains and reducing your position size. The game of trading is
the game of locking in profits. No secret here. But, the best traders lock in
profits at the right time. And, in my opinion, one of the better times to be
taking profits is when the market is in a vulnerable (and likely) position to
reverse. Markets move stocks, not vice versa, and the overall market is
the best way to gauge how and when you should be locking your stock gains in.

Next week, we’ll focus on the dilemma of “getting taken out” at the highs/lows
of the day.