Why you should Raise Cash During a Market Correction
Raising Cash
Raising or going completely to cash during a market correction is an excellent way to protect hard won profits and preserve your confidence. Going to cash should be done systematically as you get stopped out of positions as market conditions change and there are increased signs that the market health is deteriorating,
Just to be clear, this article is written primarily for traders, not investors who use DCA. Additionally, If you are a day trader, the added volatility during a correction can actually present many opportunities for you on the shorter timeframe.
Now let's get into it.
Our goal as traders is to see an increasing equity curve and to compound our accounts. To do this adequately we need to:
Focus on high probability setups and environments
Limit drawdowns
When a correction occurs volatility increases and setups which would follow through strongly in a good market often fail quickly. As the character of the market changes, it is extremely important for traders to recognize the signs and alter their activity accordingly.
Watch for:
Market Leadership breaking key moving averages on high volume
Failed breakouts from loose bases
Market Indexes showing clusters of distribution days
Market Indexes breaking key moving averages
Earnings Gap ups getting sold into the end of the day
Tight setups up the right side of bases failing instead of following through
When you start seeing these signs and the market health begins to deteriorate, it's important to change how you are trading in response. This includes decreasing your overall exposure, limiting open portfolio risk, limiting the total number of positions, and being more selective with trade setups. In a corrective market, your priority should switch from stepping on the gas and performing to the long side and instead focus on limiting your total drawdown and protecting your account value.
During volatile and down-trending markets, many newer traders feel like they need to match the pace of the market and set stops wider than they would during a normal uptrend. This is the opposite of what you should do. You never have to trade; the end goal of trading is to make money, not place trades for the sake of trading. Based on William O’Neil’s research, 75% of stocks follow the overall trend of the market. Long setups during a correction only have a 25% chance of bucking the trend. The key is to accept that trading during a correction requires less activity, tighter risk management, and tighter selection criteria if you do trade. Because the deck is cold and the probability is against you, it is usually best to limit exposure significantly or go pretty much all cash. Remember, the goal is to make money, not simply trade for the heck of it.
Being primarily in cash not only helps preserve your financial capital but also your mental capital. Trading during volatile periods and forcing less than perfect setups can be exhausting. Many traders who do continue trading during corrections shorten their timeframe and day-trade. This can lead to increased stress and mental exertion since day traders often have to watch their positions carefully. This stress adds up and might mean that you are not mentally ready to take advantage of opportunities when the uptrend begins once again.
Key Takeaways
All in all, during a correction and choppy markets, it is often beneficial for traders to limit their exposure and raise cash levels. Raising cash helps preserve your financial capital by decreasing the severity of drawdowns and preserves your mental capital by reducing stress. During corrections, I would suggest that you spend more time studying the markets, exercising or any other activity other than trading. Preserving mental and financial capital allows us to be ready when conditions improve in the market so we can capitalize on the next opportunities.
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Take care!
Richard