Financial assets don’t always go up in a straight line. For example, while American indices like the Dow Jones, S&P 500, and Nasdaq 100 generally go up in a long period, there are periods when they go through a market sell-off.
For example, all these indices slumped during the Global Financial Crisis (GFC) and at the onset of the Covid-19 pandemic. As more countries moved into a lockdown, market participants worried about profitability and the potential of the biggest recession in the world.
As shown below, the S&P 500 index also slumped in 2022 when the Federal Reserve hiked interest rates.
Sadly, such sell-offs happen in individual stocks every day. For example, some time ago, Netflix stock dropped after the firm announced weak earnings (as shown in the following pic). In this article, we will look at some of the top strategies to use when trading during a market sell-off.
Contents
What is a stock market sell-off
A stock market sell-off is a situation where stocks are falling for a certain period. In some cases, a sell-off can take place in a single day or in an extended period. As shown above, the pandemic sell-off happened within a few weeks while the one in 2022 took several months.
Causes of a stock market sell-off
There are several causes of a stock market sell-off. Some of the most popular ones are:
- Weak corporate earnings – In some cases, a stock market sell-off can happens when many companies publish weak earnings. Weak results by some influential companies like Apple and Microsoft can trigger a sell-off.
- Natural events – Natural events like the Covid-19 pandemic and the Japanese earthquakes can lead to market sell-off.
- Monetary policy – Monetary policy issues like high-interest rates and quantitative easing can lead to a major market sell-off.
- Technical reasons – At times, there could be a market sell-off because of technical reasons, especially when stocks are at an overbought level.
- Geopolitical tensions – Geopolitical tensions between important countries like the US and China could lead to a market sell-off.
How to know that a market sell-off is about to happen
It is often difficult to know when a stock market sell-off is about to happen. Advanced traders look at several things.
For example, some predict when the sell-off is about to happen by looking at reversal chart patterns. Some of the most popular patterns are: head and shoulders, double or triple-top, and rising wedge patterns.
Some traders also look at candlestick patterns. Examples of candlestick patterns that predict when a sell-off is about to happen are doji, shooting star, and hanging man.
Finally, technical indicators can tell you when a sell-off is about to happen. Oscillators like the Relative Strength Index, Stochastic Oscillator, and the Commodity channel index can be a good predictor of a reversal or a market sell-off.
Waiting for bearish consolidation
A strategy that has proven relatively profitable is waiting for a bearish consolidation after a sell-off. Ideally, when the price of a financial asset declines sharply, it reaches a point where traders start to question the strength of the sell-off.
In this period, some buyers start coming back while some sellers start exiting their trades. In most cases, this period usually has a psychological importance.
Take advantage of the consolidation
For example, it can be the point where it retraces 38.2% or 52% Fibonacci. It could also be the lowest level in a week or month. Therefore, since you will often miss the initial sell-off, you can take advantage of this consolidation.
Watch for the next decline
In the past, we have talked about the bearish flag and bearish pennant pattern. A flag resembles a parallel channel while a pennant looks like a triangle pattern. Once you spot the pattern, you can place your short trade and take advantage of the next phase of the decline.
A good example of this is shown in the Netflix chart below. As you can see, the price sold-off after it missed on the estimated user growth. As of this writing, the stock is in a bearish consolidation process as traders question the next movement.
Ultimately, there are higher chances that it will break-out lower.
Dollar cost averaging
Dollar cost averaging is a trading strategy that is often recommended for long-term traders. The idea is relatively simple. Assume that you are increasingly bullish on the stock of a company that is trading at $100 and you have $10,000 to trade. In this case, you can easily buy 100 shares.
Alternatively, you can divide the funds into 4. In the first part, you can buy 25 shares when the stock is trading at $100. If the stock drops to $98, you can spend the rest $2,500 to buy 25.5 shares.
If it drops to $95, you can buy an additional 26.3. And, finally, if it drops to $92, you can buy $27 shares. In total, you now have 103 shares. As such, if the stock finally rises to $110, you will make a bigger profit.
As a day trader, using this approach is relatively difficult. Indeed, it can be damaging to your account because you will be adding to your losses. Therefore, we recommend that you use it primarily for your long-term accounts.
Using support levels
Another approach of trading during a market sell-off is to identify key support levels. The idea is to keep shorting once bears manage to push the price below a certain support level. Fortunately, there are several approaches to drawing these levels.
Fibonacci levels
For example, you can use the Fibonacci retracement level. In this case, if the price moves below the 50% retracement, you can be certain that bears will continue pushing it to the 61.8% retracement.
Similarly, if it moves below the 61.8% level, you can short the asset because it will increase the possibility that it will continue falling.
Pivot Points
Another way of using support levels is to use pivot points. These are points that are drawn by considering the open, high, low, and closing prices (here we talk about OHLC Charts, if you are interested). Examples of these points are the classical, Woodie, Fibonacci, and camarilla.
The idea is that you should continue selling once bears overpower the support levels. Examples of the Fibonacci and classical pivot points are shown below.
Final thoughts
A market sell-off is usually a difficult time for market participants, especially long-term bulls, who suffer losses.
However, it is an opportune time for short-term traders, who can make money by both shorting the asset and by buying when the price bottoms.
External Useful Resources
- The Only 2 Moves to Make If the Stock Market Sell-Off Continues – TheFool