5 Rules to Trade a Sideways Market

by Jim Woods | November 21, 2011 8:00 am

The latest sideways market gyration, primarily driven by the uncertainty over Europe’s still-unresolved bailout deal, has many traders scrambling to try and navigate this sideways market. Certainly, the volatility we’ve seen in stocks over the past two months — a September decline of about 7% on the S&P 500, a near-11% surge in October and a November that started with a boom and now is down 3% — has a lot of investors scrambling to get on the right side of the trade. The recent volatility has prompted numerous market pundits, mutual fund managers and stockbrokers to come out and claim that trying to trade the market is a losing game, and that what’s best for investors is to just buy and hold stocks for the best results.

Unfortunately, the facts just don’t support that thesis.

If we widen the angle on our market lens and look at what’s happened over decades in stocks, we see that a buy-and-hold strategy has delivered anything but stellar gains during huge chunks of time. In the chart below of the Dow Jones Industrial Average since 1928, we can see how roughly the past 10 years in the market has essentially provided investors with negative returns. The chart also shows that the last 10 years has been anything but an anomaly.

Click to EnlargeFrom the mid-1960s to the early 1980s, there was a period of 17 years where a buy-and-hold investment in the Dow would have netted you a -1% return. If we go back even longer, we see a 25-year period from late 1928 to late 1953 with a total return of -1.5%. So you see, the notion that buying and holding stocks in a broader sideways market is the way to go just does not comport with reality.

So, what is an investor to do? How do you make money in stocks when stocks are basically going nowhere? The only viable solution is to do exactly what the buy-and-hold advocates don’t want you to do — and that is to be more active with your investment capital by trading stocks.

Of course, not all trading strategies are created equal. Day trading in and out of positions is almost never suitable for the individual investor trying to increase his/her total wealth. However, making sure your money isn’t exposed to a big downturn — such as the selloff that took place from late July through early October — is critical if you want to preserve and grow your investment capital.

While trading stocks can take many forms, there are some basic guidelines that apply to any trading plan if you want to maximize your chances of trading success.

Here’s a short list of five rules to follow that will help your trading plan succeed:

Rule #1: Diversify Your Trading Capital Allocation

If you have a huge percentage of your total trading capital allocated to just one or two stocks, options, etc., if one or both of those positions falls, your entire trading account is compromised. If, however, you have at least four or more holdings in your trading portfolio at any given time — and if those holdings each contain an equal percentage of trading capital — then any decline in one or two stocks can easily be absorbed.

Rule #2: Set a Price Target Before You Enter the Trade

Whenever you enter a trade, you usually are expecting that your stock or option position will rise, but how much of a rise are you expecting and what kind of gain are you prepared to take? These are questions only you can answer for yourself, but a general rule is not to get too greedy. If you set a price target in the neighborhood of 8% to 10% above your initial buy price, and your position then hits that target, you can either sell the position and bank profits, or you can take at least some of your gains off the table and let the rest ride.

Rule #3: Set a Stop Loss on Every Trade

The flip side of setting price targets is setting stop losses. By placing a stop loss on all of your trading positions, you will ensure that you never take a big loss in any one position. Like price targets, the exact point at which you place your stop losses is a question only you can answer, but a good rule of thumb is to never let a position fall more than about 5% to 10% before you sell.

Rule #4: Never Chase a Loser

Another rule that goes hand in hand with setting stop losses is to never chase a loser. This serious mistake can be a real killer for traders, as it locks up the capital originally invested in the position, then locks up more capital as that position is purchased on the way down. The simple fact here is that the sooner you cut a loss, the sooner you can make up the loss.

Rule #5: Stick to Your Strategy

There are all kinds of trading strategies out there. Some are very aggressive, swinging for the fences on every trade, while other more conservative strategies try to hit singles and doubles on a consistent basis. Both kinds of strategies can be successful, and there are many styles of trading that can work.

However, one thing that usually doesn’t work is to begin trading with a certain strategy and then abandon the principles of that strategy too early. Here the old adage “don’t change horses in midstream” should be kept in mind. If you’re trading according to a specific strategy, at least follow that strategy’s tenets all the way. Doing so will allow you to objectively assess whether that particular approach is right for you.

This article originally appeared on Traders Reserve[1].

Source URL: https://investorplace.com/2011/11/sideways-market-investing-rules/

---