Trading US equity index SP500
“The four most dangerous words in investing are This time it's different.” Sir John Templeton
It is often a good idea to diversify your daily exposure as much as possible or to implement trading across the assets that are as little correlated as possible. Only this way your edge can shine through and the impact of luck diminishes. It is not just a good idea to be exposed to non-correlated assets on intraday trades, but as well to be exposed to assets in different time management requirements.
For example, certain assets or trading approaches are highly time demanding while other might be much less time demanding, ideally trader should be mixing between the two to squeeze out of the trading edge as much as possible (decreasing opportunity cost). Stacking trading approaches that are all very high at risk, and highly time-consuming is not ideal, as one is increasing mental capital burn, and potentially increasing too much risk on trading. It is actually better to add hybrid approaches, so that trader has exposure to calm market, as well as a very exciting more volatile market with low time intensive and high time-intensive trading approaches (as those each balance and fit together better to maximize time expense versus the output).
For small-cap traders, crypto traders, or stock traders in general, it is great to be exposed to the US equity index - SP500 on a daily, weekly, or monthly basis as such a less time-consuming approach offers a great complimentary trading routine.
Especially if one is swing trading SP500 / SPY it usually does not consume a lot of time to place or exit such positions, the levels can be pre-determined ahead and by using price alerts (pre-set at specific levels) trader can straighten the whole trading approach a lot, cutting the time requirement down to as little as 10 to 20 minutes daily for SP500 (or even less once the routine is well established).
"There will always be bull markets followed by bear markets followed by bull markets".
Sir John Templeton
The main idea is to be playing along the bull cycle of the equity market, longing equity index along with it until the crisis cycle hits. On average the bull cycle lasts 7 years (roughly, could be anywhere between 5 to 11) after the last crisis ends, so there is a potential expansion coming after the end of the current crisis cycle, giving plenty of opportunities to long for years to come.
For the reader not to be confused, trough article sometimes the word used for the US main equity index used will be SPY and in other cases US500 or SP500, they all represent the same asset more or less. They are just different assets in different brokers (Forex or equity brokers) but in reality, all of those assets are trading 1:1 correlated, and are more or less the same.
Trading method of choice
The focus of this article is not as much about providing specific entry or exit rules on how to trade the main US equity index, but rather the overall reasons of why to trade it and the broader idea into which the trader could fit his/her approach into. There are many different directions that one could potentially go about trading it, whether it is dip buying, breakout buying, trading with momentum, trading of consolidations, many different approaches, and since there is "no single way to skin a cat", the focus of the article is more on the external areas about SPY trading which are timeless and hold the test of time no matter which approaches the trader decides to go with.
No matter what trading approach one decides to go with it should be backtested, especially if it is robust enough to be backtested. If the approach is very conceptual and the trader uses very small position sizes then perhaps it might not be as critical to backtest the approach, but for any higher risk and very well defined approach (perhaps with the use of indicators or price specific entry rules that can be tested historically) then the trader should take the time to first backtest the approach if it delivers positive expected results historically.
Manual or automated backtest?
One can perform a manual backtest by calculating the R (unit of risk) gathered/lost performance historically with a specific method, using a pen and paper, going through historical charts, day by day.
Or secondary route is to build an automated backtesting algorithm or EA (for MT4) which does the same task of gathering the performance, but if one does decide to use such an automated approach, make sure that the data counted is valid and to always double-check all the data that such automatic/robotic system has counted, to see if there is any noise within the data counted. Using automated approaches is also going to apply to limited trading approaches since many discretionary approaches will not be suitable to be scripted/programmed and that is okay. The pen and paper method always works no matter what.
Since SP500 / SPY provides plenty of intraday historical data across many brokers, and there are plenty of trading platforms which allow the creation of simple backtesting algorithms such as Metatrader 4 or 5 or Tradingstation this provides trader ability to create simple backtesting environment for trading approach before placing any live capital into trading the index with a specific trading method. Sure it takes some time and work, and perhaps frustration to create such algo, but it can provide the trader with a much clearer mind if backtest results clearly show behavioral results on what is to be expected from such trading method.
The focus of backtesting should be on collecting the data in regards to:
-drawdown on day to day basis (average across 30 days)
-the negative % account balance on month-to-month of the strategy execution through backtesting
-the average expected monthly returns
-win / loss ratio
-equity curve progression (steepness, consistency, etc...)
-and the most important of course is edge expectancy, is approach profitable in the first place or not
Trader armed with such information will be in a far better position than a trader who does not perform such historical backtest of his method as he will be sailing blind, which can cause over-expectation of profits, under-expectation of losses or drawdown, and all sorts of negative cascading consequences that come from sailing blind.
Take your time and test your trading method on how it would perform on the SPY index over at least a few months of historical data before you put it into the live ocean to see if the ship even can sail for a while before delivering all sorts of unexpected issues.
There is no specific required method that trader has to go with, no matter what anyone says or who you listen to, there are "100s of ways to skin a cat" in this game. The method that you decide to go with, make sure that it suits your personality.
If you are a trader who prefers to long into dips then develop such an approach, if you are more comfortable buying breakouts, then choose such a route to create a trading method that follows buying at the key breakout levels.
The index will allow you to choose within many different methods, however in my view ideally trader has a combination of 2 or 3 different trading approaches on the index, which over the long run deliver better performance and smoother equity curve if compared to just using a single method.
There are several reasons why using few different methods that are different in the composition is beneficial. The issue that single method might have is that it might be only suitable for specific market conditions, and since market conditions such as volatility, the strength of the trend, and the depth or duration of pullbacks can change a lot from month to month basis, a single method might be exposed in certain months to providing plenty of entry opportunities while in other months it might land into the completely dry season.
For example (theoretical example) if one has a breakout trading approach, buying the all-time highs breakouts on SPY, or just breakouts of highs on 1 hourly time frame, if the overall market is in a strong bull trend then under such conditions trader might get an entry opportunity every day at least once. While if the market shifts into a deeper bearish pullback for that same one-month period such a method might not deliver a single entry over two weeks.
That is not an ideal trading approach. Ideally, no matter what type of market one is trading, the trading approach should be delivering opportunities as frequently and as consistently as possible (regardless of positive or negative outcomes on a single sample case) as that is the required component to create a stable equity curve of P/L over the long run and to not over-leverage each position to fit into traders profit appetite. Not to mention that prolonged periods of no trades can lead to all sorts of psychological frustration and weaknesses. Traders' focus should be to reduce uncertainty out of any trading approach as much as possible, which is done by increasing the frequency of opportunities as a starting building block.
Or to put it in conceptual example:
To highlight the point above let's take a random chart example from the US500 index if one is using a breakout trading approach on SPY.
The image below shows the random period where SPY was in a strong bullish uptrend, where the volatility was relatively small, and new all-time highs breaches were very common every week. Under such conditions, traders using the breakout method buying into fresh all-time highs would be given plenty of entry opportunities across this time duration.
The image below shows very different market conditions to the image above, basically where the SPY was much more range bound and choppy, where it took a while before new all-time highs were re-established. Under such conditions, a trader using the same approach as outlined above it would mean that trader would face a prolonged period of idle or no trading, basically where no real entry opportunities would present themselves.
The same would apply pretty much to any trading strategy, no matter what it is. If one has a dip-buying approach where price has to retrace a certain amount of points on the hourly chart, then such an approach would deliver plenty of opportunities in one month and perhaps very few in another month if SPY would be in a very strong uptrend without retracing much.
Or trader using a momentum buying strategy buying into strong bullish moves would get plenty of entry opportunities under months when SPY is moving strongly directionally up, and in months where there is a major market correction, such trader would not get any trading opportunities. This leads to the fact that majority of trading approaches if trader only uses single approach will have weakness in terms of frequency of opportunity exposure in certain periods/months. And this does not apply just to this article on trading SPY / SP500 but any market for that matter (which is why so much of my personal focus goes into playbook expansion).
To fix that as suggested above traders should use ideally 2 complementary approaches, each of them being complete opposites of each other (but still suiting traders' personalities and playing on traders' strengths).
For example, such opposite approaches might be a 1. dip longing approach where price has to retrace a certain amount to trigger entry opportunity for trader and a secondary approach of longing 2. break out of consolidations. Both of those methods provide entry opportunities in different market conditions and complement each other well no matter what kind of phase the market is in.
When mixing approaches traders should think not just in price terms of which methods might complement each other but as well in volatility conditions and time duration. For example, two great complementary methods are when both are suitable for opposite market conditions:
-Long-based approach on buying dips in a very strongly volatile market, where the bearish pullbacks go very quick and deep and there is high volume exchanged in the move.
-Long-based approach on buying breakouts in a very low volatile market, where the consolidations take a long time to form and the market trades on soft volume.
To outline such a combo approach lets take a look at the image below:
Ideally, a trader should have a combination of trading approaches that suit 1. high volatile market conditions and 2. low volatile conditions or just 1. strong bullish and 2. bearish momentum conditions. Traders can focus on strong/weak volatility to create specific strategies for it or focus on price bias itself (bullish/bearish), ideally, it should be a mix of both. The reason why is because trading only a single asset (SPY) on daily basis is going to provide only a limited amount of price movements and therefore opportunities through the months and trader should have different market conditions suitable methods ready for no matter what stage the market presents itself in.
If a trader is trading across 1000 assets and only trading the hottest asset of that day (for example small-cap stocks) within such a large asset base of 1000 assets, it is very likely that there will be an entry opportunity for such trader no matter what type of trading approach he/she uses, or how many different approaches he/she utilizes.
It is however very different when one is trading only a single asset every day, as the amount of opportunities is likely to shrink a lot if one is trying to force the same trading approach on it every time, especially if that trading approach is not scalping or very order flow/ tape-based (high at the frequency).
This makes combining different approaches more flexible and decreases opportunity cost each month. However, the downside of course is that it takes more time to develop two or three combined approaches with an edge compared to what it takes to develop just one. But for each extra R that one wishes to extract from the market consistently, there is a time toll that one has to pay to do so, expanding playbook comes at expense of extra homework, research, and whatnot, one should be prepared for that.
The recommendations of methods described such as dip longing or breakout buying are just two very crude methods that many traders will connect with, but by no means does it end there, the possibilities for approaches are much bigger than just that. One can use tape arbitrage for example of using ES futures big bids stacked to use that as long reasoning for scalp entries, or using the inconsistencies between assets of large indexes DOW30 or US500 as entry reasons (buying the lagging one), or using delta bid/ask absorptions as entry reasons or just number of many other methods. The dip buying and breakout buying methods are used for sake of being more commonly used for readers to connect to.
Combined approaches and recycling of position
There is a large advantage in recycling the positions, especially where a trader is exposed to the specific asset over a prolonged period where it is not just about a single "setup" on the ticker, but rather a combination of long term trading, swing trading, and short term trades. On such ticker where the trader has all sorts of single directional exposures (long only for example over several months), it is better to be recycling positions within each specific setup, rather than using single in and out entries or exits on trades. There are many reasons why, to outline some of those let's use the image example below to highlight the 1. R left on the table, the increased 2. R collected, and 3. extra entry opportunities as three main components:
The idea being, if the trader is only using a single entry/exit approach then the R amount collected is by default limited. Because in between that single entry and exit, the price can fluctuate in any direction and the trader will not be able to exit such position in gain or loss until a specific price level is hit in the first place (this creates opportunity cost).
Meanwhile, the recycling of position (multiple-scale outs and scale ins before the price reaches key target level for exiting all positions in gain or full cut) will enable to maximize the Rs. And while yes that does increase the overall loss in dollar terms of account equity if the trade does not work out, it as well increases the gains on winning positions and especially allows the trader a lot more flexibility and less idle time.
Decreasing the idle time is quite important so that trader is not just sitting in the same position for many days while the price is dancing within a specific range, the recycling of position within a specific setup (while the setup is still valid) will keep traders on his/her toes (engaged). It will as well maximize the R, and it will allow the trader to keep a certain portion of account equity open to adding to position size at a better price (for example instead of being 100% locked in position with recycling trader is usually at max 70 or 80% locked while remaining 20% is open for new additions).
Example of idle time within a single in/out position, versus recycling position and decreasing idle time:
The first image shows the single in/out position and the idle time window in between.
The second image shows recycling of position with decreased idle time in between, as long as the setup for long remains valid and invalidation level is not breached.
For any trader attempting to trade SPY over the long term especially with smaller position sizes for swing trading, it is highly recommended to implement a recycling process, and while it is difficult to get used to it, and certainly not a beginners area, one should at least practice, with small position sizes to get used to the process.
Below is an example of how a trader should think of recycling the position to increase the R collected per each trade. The example is for small-cap stock, however the same can be applied for SPY trading or any other market for that matter.
Short trade example below:
It is also less ideal to use indicators for entries because those often force traders into the mindset of a single in/out trade approach where a trader will not consider taking positions if the price is too far away from indicators specific area. That kind of approach does not go too well with recycling, for recycling traders should be more flexible and fluid. It is more about:
using the setup to trigger entry,
using setups projected path to then join and exit trade along that path,
and trade along the microtrend of projected setups path until the target is met or the setup is invalidated.
However, with that said, recycling on the entry side (no including exits) is something that beginner trader should avoid, and the only attempt after 2 or 3 years of trading experience (on avg depending on hours traded daily).
The reason being is that a recycling process can "teach" traders wrong risk management skills and habits especially if one is not very good at calculating the position size or in general very strict on discipline. Often recycling means adding too long positions into higher prices and "ruining average", thus increasing the trade exposure to errors and getting too loose with risk management in such cases could lead to too many negative consequences for the trader. It should be practiced on demo / smaller live accounts until the trader develops solid conviction and consistency of trading a single specific pattern.
The right balance between defensive and offensive stance is needed for recycling
(conviction, practice, experience else the recycling will not work)
For recycling to work, the trader needs to have the right calibration of a defensive and aggressive approach, just at the right balance. Experienced traders will probably know exactly what is meant by that, a less experienced trader might find it more difficult to relate to the concept, however. For beginner traders, it is essential to focus on developing a defensive approach, as one does not have a strong conviction on trades yet, and being defensive will always protect the capital better than being too pushing on trades without the right reasons.
However, once a trader gets comfortable and consistent with specific play over many executions and repetitions, there should be a gradual inclination to start recycling position and switching from defensive towards the more aggressive style of trading.
To recycle position, one cannot be in a defensive stance, because that by default prevents traded to add to the position at less ideal prices and to be too tight on the risk where the trade needs room to breathe (as long as the setup is still not invalidated). Therefore shift towards a more offensive style type of trading is needed. Whatever the case trader needs to shift to this style only when the performance history suggests that it is the right time to do so, no sooner than that.
However with all said above, no matter if beginner or experienced trader, a trader should always be scaling out / selling part of the position (profit taking) and not use just a single exit. Entries are subject to discussion whether a trader should implement recycling and scale on them, but one thing that is out of the discussion is whether one should be scaling out in chunks profitable position. The answer to that should be yes, for the majority of cases. There are many benefits of doing so, even if one is a complete beginner trader. Especially for anyone frequently trading or being exposed to the SPY index, it is always worth selling chunks of position (long) if the price is moving higher into trades favorable direction so that there is always room in buying power/account equity for fresh adds or just fresh trades in general. And not to mention to lift some spirit in morale since any small scale-out will count as a winner.
Always scale out profit-taking in chunks along the projected path, never in a single exit. One never knows when the price might turn full 180 degrees.
Expected traded range using volatility expansion/contraction as a guide
K. McCullough has one thing right for sure, using moving averages to trade SPY long directionally is a very outdated approach, more suitable for the 1980s rather than the 2020s. Being too static in entry executions along with specific indicators especially if the indicator does not adapt to volatility shifts too well is just sub-optimal in performance especially when it comes to the trading specific single asset. A trader should have a pulse on the volatility changes in the SPY index, rather than looking at market/price behavior strictly from where the price is relative to some pre-defined indicator level or price level.
When volatility shifts strongly with a quick bearish move the trader should:
expect a potentially deeper move
position potential dip buy entries lower
While if price retraces (pullbacks) at very weak volatility (soft selloff) then the trader should:
expected shallower move
be inclined to buy earlier
Above are very rough guidelines to use and by no means a guarantee in how the index should behave.
A trader should pre-plot potential range expectations around which the SPY should trade (using the macro time frame of H1 or H4) and then adapt the trading decisions based on how the price and volatility reacted within the pre-determined range.
To outline the process, my process consists of plotting two range expectation zones, which are calculated based on a maximum expected pullback of SPY (more about that is outlined in the article below) and both of which zones are dynamically adjusted as the price updates on H1 time frame.
The image below shows how both of the zones are moved higher, if the SPY index moves higher, and the amount of price that zones are moved higher is based on how quickly the volatility (the strength of bull leg) has expanded. The quicker it expands, the more the zones are moved higher, the slower it expands, the more zones remain anchored to the similar price where they are.
The overall idea is too long with higher conviction trades and size at deep zone, and slightly smaller size and less of trade frequency in higher mild zone.
Personal approach (playbook)
As stated above there are many ways to approach the trading of SPY and that is up to the individual to figure out but to not theorize too much about possibilities, lets outline a personal day-to-day approach on trading SPY / US500.
Typically my daily routine/frequency is between 1 to 3 trades on SPY almost every day, some of which are smaller in size, some of which are larger (up to 5X the smaller trade size), depending on the entry opportunity, quality of setup, and the overall approach used (and the risk levels set). Usually, this means recycling long-term exposed position(s) which will be smaller in size and are usually swung over 3 to 7 days on average, which represents half or more of daily taken trades on the index. Or in other words, less than half of positions are fresh new entries, half are just selling/take profiting from previously held positions overnight or adding size back to the already held position at a similar price.
Below is an outline of the two main personal complimentary trading approaches used on daily basis.
1. Modified dollar cost average approach (constant bullish exposure)
"Dollar-cost averaging (DCA) is an investment strategy in which an investor divides up the total amount to be invested across periodic purchases of a target asset to reduce the impact of volatility on the overall purchase. The purchases occur regardless of the asset's price and at regular intervals. In effect, this strategy removes much of the detailed work of attempting to time the market to make purchases of equities at the best prices. Dollar-cost averaging is also known as the constant dollar plan."
Example of DCA trades:
M-DCA positions are there to provide constant core exposure to the SPY index and ride it along with its long-term projected bullish move higher. The position is typically scaled out in chunks as the price is moving higher and then added to its original size again over time. It is a modified dollar-cost-average approach, where it is not as much the entries in terms of price that matter, but rather the time of position exposure, and the time that has to pass to place fresh size back on.
It is somewhat similar to average dollar cost buying the asset where one puts X amount of USD every week into buying an asset, but besides that, the gains are sold frequently, just so that there is always the ability to lock some profits and to re-load fresh size from whatever the price that index provides on any further random day.
The reason why using such a modified DCA approach versus the normal DCA approach is that with normal DCA usually traders or investors do not leverage their position, it is a full cash position. But with the modified approach used above personally, one can leverage positions much more, and recycling and locking gains along the way provide the ability to increase R collected relative to taking full cash position with a more simplistic DCA approach. This approach is critical due to the non-cash leveraged position and therefore it has to be modified DCA (DCA standing for dollar cost average).
Such positions of modified DCA will then be recycled and the core of position will always be placed back sooner or later (usually no more than 2 days in between), and the position is always scaled out by 20% or 40% into strength, and then placed back on after few days (preferred into a dip, but sometimes even into strength if the market is not retracing much).
The position is weighted on a scale so that if the market retraces 35 points in the SPY index the account equity exposure is no higher than 10%. This is the rule used at all times. Read further along with the article on why 35 points is the depth used (for current 2021, by no means is 35 static number that can be applied to just any year, it is the volatility adjusted for current SPY price of 400.00).
Example of such core position recycling for DCA position:
2. Accumulations and extensions
The second approach which does not include constant exposure to the market, (because those are very specific opportunity-based setups) is using specific micro patterns outlined on the blog and trade those when the opportunity arises. Those are all much stronger in sizing relative to approach 1. and require tighter risk.
The key two patterns traded are both the opposites of each other, providing a good combination no matter in what condition the market is in:
For accumulations, the SPY has to be in a bullish uptrend under low volatile market conditions (small range) and it has to form a decent consolidated pattern. Check the blog article on accumulation play to inform yourself on what it is meant under this trading approach, but to sum it up quickly:
Accumulations are especially present in bullish market conditions, the stronger the market overall is, especially if volatility is smaller, the better the chances are for accumulation play to deliver potential opportunity. Those are good trend following opportunities.
Example of two accumulations on intraday charts of SPY index:
The amount of accumulation plays depends completely on the overall market condition. In a strong bullish market, especially where the market is making new all-time highs on daily basis it is frequent to see one or two accumulation plays every day. While in a market where there are more bearish pullbacks it is less common to see a higher amount of accumulation plays and there might be a more dry season in regards to that for one or two weeks.
The bearish extension is a play on where the SPY tends to be more volatile and there are relatively stronger market selloffs that are not accompanied by any major bearish catalysts. This is critical, one should not be dip longing bearish extension early when there are major negative catalysts present, but rather when the market sells off for no apparent reasons, as it is most likely just a cascading profit-taking event taking place, this is where a trader should focus on buying the dip.
For extension, the price has to move in consecutive several bearish candles and it has to pass a certain % drop threshold which for the case of the SPY index means more than 1% ideally. The more the better. Often those strong bearish corrections are as well quickly corrected in a highly volatile market, which allows the trader to resolute on position quicker and sparing the buying power for further use on some other positions. The quicker and the sharper the selloff, the quicker the retrace back up usually, not always of course.
Ideally, the extension is followed by a climax volume candle present on the potential bottom of the move, to support the bottoming and reversal thesis with higher probability. To read more about what extension is or how to trade it check the "trading extension" article.
Let's break down what is meant as an extension and what it is not (both examples from SPY index):
Extension move ideally should be at as high volatility as possible (trader can use ATR indicator to estimate the change in volatility rise if one is not good at spotting that strictly from price itself), and the % move should be as strong as possible within a short time window as possible (for example 2% move in 30 minutes). Usually, those violent selloffs are met by quick and sharp reversals giving traders a good opportunity for quick in and out trades, or to add to swing position.
And below are some medium-grade climax examples on large-cap stocks, and the same concept applies to SPY in general.
My preferred method is to always set some random price alerts on SPY at the start of every trading day, setting them to lower from the current trading price, just in case if there is a sharp selloff where the extension might come into play it gives indication some minutes ahead to prepare for it, especially helpful if you do not keep a steady eye on index every minute of the day.
Setting alerts is critical not to miss the opportunities, and sure it does mean that there might be some un-needed noisy sound alerts ringing each day here and there, but that is well worth it to catch those opportunities that do count (one in four or one in six for example). So for example, if SPY is trading at the 400.00 marks currently, alerts will be set at 1% and 2% lower of that price, certain X points under that 400 mark.
Examples of extension play in SP500 recently (always use volume indicator on extensions to identify the climaxes for potential bottoming, the examples do not provide volume due to reasons to fit them all in a single image):
If you do use volume indicator to identify potential climaxes, make sure to use stock specialized brokers for volume data, where the data comes from the Nasdaq centralized exchange. Do not use CFD instrument data which is often not centralized as that will provide too unreliable volume data and often miss the mark on climaxes. And for futures markets, if you do use that for volume data then ES is a decent instrument to use, and less liquid instruments will have less reliability. Always use the intraday time frames (such as 1 minute) when establishing the volume climaxes, never higher time frames such as M15 or H1 time frames, because the volume imbalances there are always leaning higher/stronger towards market open and market close, which can give trader deceptive read on climax. Use M1 or M3 time frame as your guide to correctly identify climaxes. This process should not be oversimplified with zooming out, sometimes one has to zoom as close as possible to extract a valid edge.
Additional to the playbook setups outlined above, my usual preference is to always leave some size open on SP500 (long-only), to be exposed to the overall bull cycle inequities. It is important to have the position size of such outstanding long very carefully calculated and pre-determined, one does not want to have to high position size and then getting uncomfortable holding it if SP500 retraces 1 or 2% (which is completely normal) ending with selling the long and bottoming ticking just where the SPY reverses to the upside.
Get familiar with the beast you engage with
Perhaps a common mistake that many newer traders make is they do not check the expected historical behavior of the asset they trade, or particularly the SP500 in this case. Especially when it comes to trading major large-cap stocks which are highly correlated to the SP500 index it is critical to understand the typical historical behavior of the index. And by that there are several components within the behavior that trader should research historically to build the realistic frame of expectations forward:
-average depth of bearish pullbacks in points or % terms
-average time that pullback takes to recover back to fresh highs
-average ATR volatility on day to day basis
-maximum volatility strength days versus lowest volatility days to build the realistic frame on what to expect on black swan days or very slow days
-the number of days that the index closes green at the end of the day versus how many days it closes red
Collecting such data can be very valuable to build better expectations forward. Usually, traders do not perform such data collection or just a glance over charts in general historically to visually see what kind of behavior is expected. This then leads to the fact that the index drops 1 or 2% intraday and all hell breaks loose where traders start to ask questions and panic "what is happening"? These kinds of reactions are usually due to the lack of research.
One should first research the beast that you try to tame on daily basis, otherwise, chances are every little behavior on the negative side will cause you to panic react and lose the big picture focus. It is why there is no surprise that many traders tend to sell their holdings into 5% market selloffs just where the index usually bottoms out and bounces because the lack of research on the behavior leads them to eventually panic out after few days of the selloff, even though that proper research would let them know that this might just be the ideal time too long with maximum capacity.
Try to spend as much time as possible researching the index historically, focus on the chart first. Use time frames from 1 minute up to daily (D1) time frame to research the volatility and expected pullbacks across different time horizons. Then focus on researching historical catalysts that impacted the market, both positive and negative catalysts, so that you are prepared ahead of when similar catalysts hit the market.
Everything in equity markets repeats in cycles, something that happened previously in history will likely repeat, not the same but in a very similar pattern. The more researched one is on the index in general, the better prepared will be to handle all sorts of different situations. Or to put it in words of Ray Dalio: "Everything is just another one of those". Nothing happens for the first time in markets, it has happened to someone else already before, so take the advantage of data and research it, get prepared because chances are it will repeat, especially if you stay exposed to the index for more than 5 years, you will most likely face 70% of historical patterns. The more years that you stay engaged with the index, the more towards 80 or 90% of those patterns from history will happen to the market and hence to you, so be ready for it.
"Study the past if you would define the future" Confucius.
When it comes to catalysts, in general, this is not an easy topic to research and it takes a while for a trader to get a good enough grasp on macro topics to be able to implement them into a daily trading routine and directional bias formation for SPY index.
It takes a lot of practice, potentially a year or two, maybe even more, it is something that one should be researching but as well always checking with others who are more credible to validate opinions, especially if you are newer to macro overall. It is something that takes a while to build into a good knowledge base area, so do not force your opinions too early and too quickly. If unsure always try to avoid having an opinion on a specific catalyst present in the market, rather than forcing every ill-formed and un-researched topic into the directional bias thesis on the SPY index as it might do more damage than it does good. "Know what you don't know." Be real with what you really do understand and have been proven correct previously. Avoid what you are untested on or inexperienced with (research it and follow it, but do not form an opinion on, have your opened position strictly tied to price action only, not the fundamental thesis itself in such case).
It is easy getting married to a story
As a beginner perhaps the most critical point that one has to understand at least to a certain extent (because the reality is one only learns the importance of that through mistakes) is how easy it is to get married to stories in financial markets. The less experienced one is with news/catalyst reading, research, and trading of them, the easier it is to build bias from reading some news story about the financial asset. In many cases, for beginner traders, it will be more damaging than actually providing positive value.
People are drawn to stories, ever since the prehistoric times sitting near the campfire, do not underestimate how powerful this can be to strengthen your belief system in stories you have very little credibility to be good at judging in the first place. Especially because the SPY index is on daily basis impacted by so many different varieties of catalysts, stories that are so vastly different in their composition and knowledge areas (science, financials, law...), it is very easy to get sucked into forming opinions on something you should have no opinion on, until you really gather enough research and experience on it.
And that is not to say that beginner trader should not be reading news, forming opinions, or trading any of that, it is just that one needs a very careful approach on taking it slow in regards to that, to avoid bag holding behavior (which very frequently comes from getting married to the story too quickly). Take it slow, and always weigh your conclusion against those who have completely different conclusions than yourself, and check what justifications are they using to come to their conclusion, just in case if you have missed some critical inputs. Let me give you one personal insight learned from observing myself and many traders over many years: Everyone overestimates their ability of objectivity and ability to weigh the importance of stories in the markets when they have not been trading for a while yet.
Some example of catalysts that affect the equity index of the US, or just any equity indexes globally:
Examples of positive catalysts:
-central bank policies such as cutting of interest rates or quantitative easing expansion
-good unemployment or CPI numbers
-new trade deal between countries
-de-escalation of certain geopolitical situation that country was involved in
-political stability reached (if previously unstable) often after fresh elections
Examples of negative catalysts:
-political instability (if populists are elected which are usually against the status quo, markets do not like such parties usually as they provide too much uncertainty)
-bad unemployment numbers, high inflation reports
-major drop in natural resource prices (if the country is a major producer)
-escalation of fresh geopolitical situation such as proxy conflict, threats, sanctions
-central bank policy of raising of interest rates un-expectedly by large % basis
-major bank failure
Researching those catalysts in hindsight and then noting the moves that happened, and placing those within the pattern, and then collecting as many of the same patterns historically over 200 year period will give traders better projections on what to expect. However, also take a note that certain conditions within the markets do change and certain patterns/catalysts might not leave the same footprint on the market currently in modern markets as they did previously historically. There might be certain deviations depending on how the markets have changed, but roughly the reaction (positive or negative) might remain the same, directionally speaking (the magnitude might change, however).
Average pullback depth in a bull cycle
For a trader with the more loose approach in trading of SP500, for example with smaller position sizes and wide stop losses, while recycling position into dips and selling pops for smaller R it is important to keep the average pullback depth as a rough guide on what to expect as a maximum potential pullback depth of the move. That maximum should dictate on what kind of size can trader afford to place on such position so that if this maximum pullback occurs the trader needs to be comfortable with holding the drawdown % without panic closing the position. What that number of account % exposure might be is something that everyone has to figure out for themselves, their risk appetite, and so on. Also, it very much depends on how early into the bull cycle the equities are in general (time passed since last crisis in years), because the more time it has passed since the last crisis the more chances are for a new one to happen, increasing the chances that the maximum pullback might lengthen into something far deeper. Mind that the maximum pullback depth is only estimated and used for the bullish cycle pullbacks, not the crash move that happens during a crisis!
In later stages (5 years since last crisis plus) of the bullish cycle, a trader should have less exposure of equity % on such a position, and earlier into the cycle (1 year since last crisis), there should be more aggressive exposure.
The average expected pullback depth personally used on the SPY currently is 35 points. That number is calculated based on visual moves of the SPY chart and then adapted to current markets volatility (for example 10 years ago volatility was smaller so the move in points was smaller as well, but has to be raised in the current market as volatility is expanded and the SPY trades at higher numbers).
Let's take under the assumption that the trader decides to set such position size so that if such maximum pullback expected is to occur, the trader has a maximum of 10% of negative account equity exposure to such move, and the price move down assumed to be 35 points for SPY:
At any times trader needs to calculate how many shares to hold at each moment for those 35 points to always represent a max of 10% of the balance (using position's average price if the position is split across different price points).
For the sake of argument, let's take a theoretical example wherein such case trader with 30.000 USD equity would be buying approx 120 shares of SPY to conform to the approach outlined above (on margin, since 50 shares would have to be borrowed on a 1:2 margin as cash would not be enough for entire position).
This method is only outlined for the modified DCA approach, not just any general trade on SPY to be clear.
Also please take note, that "maximum expected pullback" is not a maximum in an absolute sense as the market can move beyond such an expected point. It is only within statistical probability that the market should not pass that level by much, but it is not a guarantee by any means. There could always be some unexpected very bearish event happening in the globe turning into the black swan, but then again the trading is not about expecting low probability scenarios around every corner and then avoiding and missing every opportunity because of that. It is about balancing the odds well and being risk-management prepared for either way.
Trading call options
Another route that traders can take is using call options to trade SPY / SP500 instead of going through equity or CFD instruments. The upside is that it might take a lot less buying power to trade options relative to SPY equity long (although there is not much difference to trading CFD instrument at high leverage), however, the downside is that options tend to be less flexible, especially compared to CFD instruments.
Also the shorter the duration that trader picks on options the more difficult the edge is, the longer the expiration of options, the more straightforward the edge is, but the downside is that the cost of options increases, and the overall RR decreases. There are pluses and minuses, however, it provides a solid complementary approach to just using CFD or equity longs on SPY.
My personal preference is to have under 20% of equity long exposure within the options on day to day basis, and the majority of options trades are 4-day expirations for call options (often out of the money calls which are cheaper).
Overall options are not a very beginner-friendly instrument to trade, especially if one is not familiar with how time decays the value of options and why timing certain moves in options are good to help with increasing the RR (especially if one holds them to expiration). However on the upside, if there is a market where one should train at options trading and improving overall skills perhaps the SP500 / SPY is the way to go, especially on the long side. The liquidity is always there, the bull trend often helps "flooring" the value decay too much, and there are always dips too long as well frequently.
SP500 index trading is a solid environment to train on how the options especially for smaller accounts since the max DD of account equity exposure is likely to be lower if one keeps longing the dips, compared to some other large-cap tickers with more dynamic trends where having a prolonged large pullback is much more likely (for example 2 month of selloff) relative to SPY. Important info to keep in mind, a frequent mistake that beginner options traders tend to make is they get involved with very volatile large-cap tickers at extended up trends buying the calls without realizing that once that trend shifts it could be a long while before it retests all-time high again, something that is far less likely to happen in SPY, and that could have large consequences to account balance, especially if one takes many losses in a row buying the dip that never comes.
VIX volatility index (ticker VXX)
A very basic rule in markets is that equity markets take stairsteps up and elevators down. This statement can be well summarized by the picture of the VXX volatility index chart where the VIX is progressing in slow condensed moves to the downside when equity markets are in a bull market and the VXX starts strong bullish expanding moves to upside if equity markets enter the bear phase. In other words, the peace at which VXX / volatility moves to upside (bear equity market) is much quicker than when it moves to the downside (bull equity market), reflecting the analogy from above (stairs/elevators). Basically, VXX moves inverse of that, elevators up and stairs down.
Understanding this basic relationship is critical in establishing better long or short opportunities in equity markets, or at least to better pick longer-term trend direction.
VXX is often going to be a good indicator for showing when the bearish moves in SPY are not just profit-taking moves, but rather a decent bearish catalyst reasons moving the markets to the downside, giving trader hint for the potential further selloff.
Vix index is the reflection of expanding fear, capital outflows, and fear factors in the financial system and equity markets.
The very basic rule to follow in the bull market:
When VXX is expanding to the upside (strongly) keep away from longing equities if there are strong bearish catalysts present.
When VXX is contracted or idle or dropping, press with long positions on breakouts.
VXX and SPY are usually in an inverse correlation. When equity markets move higher generally VXX will move lower and vice versa. However, it is not that typical inverse correlation that is useful and creates the edge. The edge is created when there is a significant change in behavior or disconnect from typical inverse correlated behavior. For example when VXX over-reacts relative to typical correlation.
One thing worth mentioning is that often traders come with suggestions to long the VXX or buying call options on VXX as a hedge to the SPY / SP500 longs. I would not recommend such an approach, using that approach randomly without being tuned with catalysts on the broad market will deliver too many losses on VXX and too many call options expire worthlessly. In a typical equity bull cycle, the VXX will keep dropping lower, and the issue is that VXX is a volatility instrument where the actual value is exponentially decreasing over time, which means that it is that much more unlikely for a trader to be "bailed out" of bad positions (longs) because the value just does not return to the bagged long levels unless there is a strong bearish catalyst that hits the market and spikes the VXX.
To illustrate the concept, image below:
With that said, it does not mean that one should not be using VXX to hedge SPY / SP500 longs, it is a great tool to do so, however, it is not a beginner type of strategy, and even experienced traders might struggle with it, since the timing and knowing which catalyst truly has potential to deliver strong bearish moves on SPY is a required component to rationalize correctly, otherwise, it will not be worth implementing VXX as hedge instrument. Or with other words, it is a lot more difficult than it looks on the surface.
My preference is to not hedge VXX in the bull market cycle, but instead only to long it in the crisis cycle, instead of having exposure to SP500 or SPY shorts for few reasons:
-it takes a lot less buying power to swing VXX compared to SP500
-no short overnight fees
-higher RR / volatility
"Cleaning up the SPY index"
A trader could as well use the method where only specific assets within the SPY are traded, those that trader deems to be the strongest companies which are most likely to hold the uptrend and be at lower risk of delivering major bearish pullbacks.
Many long-biased large-cap stocks traders have issues, not with the fact that those assets correct or have pullbacks. It is the fact that it becomes an issue when the pullback is quite deep and the price just keeps holding weak for a while. That is when often traders get shaken out, due to many reasons. Often their patience breaks, or they just lock too much buying power and have to de-leverage by just closing positions that do not perform for a long time. It is why it does help in filtering the assets that are less likely to have deep pullbacks that hold for a long time weak before they return to their fresh highs.
The example below illustrate what is meant by that.
So one might ask, well how do you know which assets fit then such filter criteria, to create your own "filtered" SPY index to trade? Well, this is where it gets complicated, very fast.
There are several ways to go about creating filtered/polished higher grade SPY:
-by looking at a historical macro chart of assets and only including those with very steady up trends and no major prolonged pullbacks that last for few months for example. Only assets with at least 3 years of prolonged bull trend count, no emerging assets with trends under 1-year-old.
-by researching the company, its growth rate, fillings, the cash position, and others to only include strongly growing better-positioned companies, and excluding riskier ones that might be more prone to market bubbles or overall corrections (if the situation changes).
-Using sector strength to include/exclude tickers based on the sector that is currently in play (for example if the oil market is strong lately then including more energy large-cap tickers, if the oil market is weak, then excluding more of such tickers).
There are many ways on how one can refine that SPY tickers list, its a long process but it might be well worth it.
Overall creating such a filtered index creates another problem, it is that trading becomes much less straightforward as now one does not place all trades through a single instrument most likely, but instead has to place it through the bulk of instruments, making it more complicated. There are however certain software such as MT4 for example which allow creating of custom indexes that allow as well then trading of those, but I have only tested that for currencies, not equities.
Also, it should be well noted that if the trader does go about creating a better filter of SPY assets, certain sectors are a lot more dynamic overall, especially those exposed to prices of resources for example (energy), and those that are a lot more stable in their income and thus less exposed to potential shock scenarios (such as financial transaction tickers such as PYPL, SQ, etc). Ideally, traders should include a lot more tickers that are not prone to shock situations and have much more stable income which is less likely to change within a short period (excluding crisis scenario as 2008 or 2020).
Recency bias and expecting doom scenarios too early since the last crisis
Often traders tend to oversimply the whole crisis-bull cycle within equities, and the price itself can be an issue adding to the flame. Basically, traders will see SP500 pushing in a consistent uptrend for a month, and then starting to anticipate all sort of bearish scenarios just because of that, and pulling back on longs due to fear of "chasing at high prices". The reality is if such predictive behavior is taken into the historical performance of typical SP500 behavior it just does not make much sense.
First of all, it is normal for SPY / SP500 to perform a grind-up trending behavior that can often last for few months in a row. And more often than not such behavior is in a broader sense extended from months into years.
Expecting a crisis to strike just because "market is too high" is a very flawed concept a trader should by no means operate with such an oversimplified look at the market.
Having a skeptical view on potential crisis scenario to strike when the equities are in a rally for several years is healthy, having such a view just a year since the last crisis and using "high price" of the index as justification however is a full no-no. Historically it holds little-to-no water. Avoid such a mindset that is highly common within beginner bearish-biased communities. It is common that especially within the first year after the recent financial crisis, the sentiment gets quickly tilted into bearish side by market participants, blowing any micro bearish event out of proportion, into expecting "here we go again" of another crisis event. Recency bias without proper extended historical context is a very deceptive cognitive trap, do not fall for it, always operate with broad context to avoid such traps.
Let's get one very important fact right. How many market participants are actually able to accurately (well-defined reason and right timing) to call the crisis and equity market crash to happen? Very very few, under 1%. So when you see a very condensed opinion of everyone jumping on the bandwagon of calling a crisis due to some market event of small scale that is present just half a year since last crisis has begun, statistically it is highly likely...it will not have followthrough. Not then, not a few years later on. And when the time really does come for a crisis to strike, the majority of those will be caught off guard.
That is just how the whole recency bias and the actual reality of calling the heavy bear scenarios in markets work out, so be on the watch for such mass behavior. To keep it simple, defining the right variables that might cause the real market crash and timing it well requires a lot more expertise than just saying "the market will crash because there is too much debt in the economy". The actual performance of market participants clearly highlights that it is much more difficult than that.
Have the concept of the typical 8-year equity cycle well studied and laid out, understanding that is critical as no conviction on longs cannot be built without understanding the time window concepts between last and future potential crisis within a realistic frame-set (image below):
More about that concept in the article below.
Interest rates and the performance of equity index performance
Interest rate cycles are an interesting concept, especially when it comes to US equity markets. Nothing is static in markets, and one cannot operate with the static market prognosis on how the equity markets should react to interest rates moves, whether its moving rates up or down if one does not include in such view economic growth, the inflation rate, the time that current rates were high or low, the rates of other global economies, the current actual absolute rate number (very low 0% for example, or very high 10% for example).
There is a lot that goes into defining how the equities might react if the central bank changes its stance on interest rates and starts new hiking or rate cutting cycle. It is by no means as simple as if interest rates up=equities down if interest rates down=equities up. Devil is in the details.
A frequent misconception is that raising interest rates (without defining any other conditions) by default should cause the stock market to decline. Obviously, history has enough examples that it is not necessarily the case, as it depends on a lot more conditions. The image below highlights few recent examples.
The point being that using interest rates hiking or cutting cycle as a sole measure of where the equity market should go or when to stop longing the equities is a very poor guide historically. There is a lot more that goes into establishing when the hiking or cutting cycle might be problematic or good for equities.
Often what matters more is not which cycle the central bank is at, but rather how drastic the plan to change rates is, how deep the rates will be cut, or how high will they be hiked is what actually matters. How deep/above inflation, growth, capital inflows, other global markets, etc, those are the real variables that help to establish when one might actually expect hiking or cutting cycle to significantly impact the performance of SPY, at least in the measurable and tradeable way.
Any policy response no matter how soft it is from FED will actually impact the equities, but if it is not measurable enough, or severe enough then the trader will be unable to act on it or will act on it expecting the too severe reaction that never comes. Many of the softer central bank actions that are slow responses over time are very difficult to measure on equity index chart performance because it is not easy to exclude out of the equation all of the other variables that at the same time impact the assets/markets performance. It is very difficult to isolate variables when you have 100s of relevant variables in play, at once (to know who is benchwarmer and who is the actual team up-holder). Especially for a retail trader who is not armed with all sorts of algorithms, it can be a monumental task defining and isolating variables in broad SP500 index, even if doing it in hindsight let alone in forwarding analysis.
As usual, my focus is always on practicality. It is too easy to go watch a Youtube video of someone giving you a 10-minute sum-up of why the central bank hiking cycle will tank the market. It is too easy. In reality, it is often far more difficult, and if you can practically conclude because the data that you look at yourself is so broad and so mixed and so confusing, then you should not be forming an opinion. Just let it slide, and focus on what is extractable for you, what is in front of you if unclear form no opinion on it.
In simpler terms, it again depends on when the central bank started to hike rates if it might pose danger to the high prices of the SPY index, if the hiking cycle starts very late into the SPY rally then perhaps it might pose difficulties to the further price rally, especially if there are signs of bubble present. While if hiking is slow at peace and starts early in the bull cycle there might not be too many difficulties to further price rally, broadly speaking. A trader should have this very rough guide to estimate on when to avoid looking at rate hikes as potential step-back from longs and where not to.
The global markets are a connected sandbox, not a closed environment separated by walls
To use the point of hiking cycle of 2015 - 2018 again, one should look at the equity markets like a global sandbox. In the modern era, capital inflows and outflows can happen with a switch of a button, overnight. Digitalization and globalization as the core mechanisms allow for relatively easy capital flows between countries, which impacts the way how global equity markets to trade. This is why it is important to never look at any market by itself as isolated, but rather within a global context. If country X might move to policy B how will that shift capital flows to potentially the whole globe (in/out) or some specific country Y (that might benefit or lose due to it). It's all about chain reactions in modern markets.
Some in context situations to highlight the point above:
-An interest rate hiking by itself might not be bearish for the equity market of X country if all the other global economies are at lower rates while achieving the same growth as country X. The capital of country X (locked in equity markets) might not see a reason to flight if there is no better space to park that capital elsewhere.
-High inflation within-country might be very damaging to equity market of such country if capital can easily leave such country to be placed into some other place where the inflation is much lower but the returns on equity markets historically have been similar and the banking sector is not prone to any failures due to inflation. Even though that inflation often is somewhat positive to equity market performance (in absolute terms) it depends on the global conditions not just per isolated example (Germany early 20th century).
-Country being attacked by an external opponent might not deliver an equity market crash, if there is no better haven place, or a country with stronger military might (2001 9/11 attack on the US). In such a case, the capital will just sit it out. Roman empire being similar case historically. An opposite of that might be Syria in 2014, where the country was attacked but the capital has left the country at a massive scale as there was an easy way to escape and the situation seemed un-winnable from the start.
Any move in the macro should be always weighted against the counterpart economies around the globe, especially countries that share similarities. Developed market versus developed market, emerging market versus emerging market, and to some extent as well cross-compared developed-to-emerging. Only that way one can realistically estimate what kind of reaction should be on a specific market within the global context.
The markets in the 21st century operate in competition just as much as any global business does. The capital asks: What can you offer me here? What rates if I park my capital in a bank, what % returns if I had parked it in equities over the past 3 years, what return on bonds? And then those numbers are compared against the counterpart economies with similar safety variables. Nothing operates in a vacuum. No global business in the 21st century can afford to operate in a vacuum, which is why it's not a surprise whatsoever why all developed market central banks all work cohesively in the same policies of very low-interest rates, QEs, and very similar broad policies. In the global market, the big dogs, stand together, because they know exactly what kind of game are playing, something that many economists tend to miss.
The emerging markets on other hand are a lot more on their own, trying to play their own game as much as possible (for example Venezuela, Turkey, and South Africa might have very different policy agendas, even though they are all technically emerging markets of the similar basket).
Understanding the world under the umbrella of sandbox rather than isolated cases, especially for most liquid global markets is of utter importance to estimate the reactions and long-term directions of equity markets. Capital in, capital out.
Why trading US market, and not EU or Japan
There are many reasons why focusing on the US equity index is more ideal compared to some other larger-scale developed markets, but to outline some:
1- Safe haven status (there usually is only one such economy/country at once existing with the ability to afford safe-haven status, as that comes due to supremacy reasons)
2- Growth rate. Having a decent growth rate is important as that is one of the key contributing factors to equity markets performance. EU and Japan have for a while been locked in a very slow or no growth rate environment, not ideal unless one selectively picks only specific provinces/countries to trade in such index. The US had relatively higher growth, especially due to technological advancements combined with higher capital inflows.
3- More political flexibility and stability creates a safer market environment ("do whatever it takes"). Now while "do whatever it takes" is a term that Mario Draghi used a lot in the past for the mandate of ECB and to save the EU from breaking up with providing liquidity measures where needed, the reality is that was by no means an easy task to achieve as it came under severe pressure and test. It is far easier to achieve whatever it takes policies in true united political economies such as the US or Japan, where the composition of the country is not everyone for themselves and a mosaic of 100s of different nations with different agendas, but rather much more cohesive, which certainly cannot be said for EU. And institutional money does not like such drastic uncertainties where the whole financial system comes under the stress of "will we make it to tomorrow or not?" as it did in the EU to a certain extent. Things like that do matter over the long run on which equity markets the capital likes to flow quicker and remain there for a long time, without pulling out at first signs of trouble. All of which means that politically unstable markets can have very surprising bearish moves, while more politically stable economies such as US are less likely to have such scenarios to happen.
4- Liquidity, leverage, volatility. US equity index is more liquid and provides more intraday volatility than the majority of larger indexes, making it a better trading environment for higher RR extraction.
Time dedication and capital requirement
Something worth mentioning is that the trading equity index is less time-consuming than many other asset classes, especially if one is looking to hold swing positions for few days. The reason being is that edge on the long side is easier to extract relative to other assets that trade historically in much more dynamic non-singular direction based trends (for example FX currencies), or certain asset classes such as small-cap stocks which require often intraday entries and management, which comes at higher time expense to control and maintain such positions.
The advantage that trading of US equity index holds is therefore:
-less time spent on managing positions,
-less stress (with proper sizing),
-higher reliance on statistical data of long term performance expectation of the asset (less uncertainty),
-very clear and transparent access to data for all the underlying assets that form the index (which is not accessible for other more exotic assets for example such as lower liquid tickers certain markets). In my view it is a solid complementary method to add into any traders daily approach, no matter what market one is trading, as long as the trader has done required research on the history of equity markets, the gathering of behavioral data of index, to be well informed on what to expect. If so, the US equity index is a solid addition to trading if one decides to strictly trade it on the long side, and is as well much more suitable for beginner traders than the majority of other assets. Sure it is not the most exciting or exotic asset to trade, and it is one of the reasons why so many newer traders tend to completely dismiss it. Or often many do not know that it is possible to approach trading of such index with relatively smaller capital if one uses CFD instruments, as trading it through equity brokers using cash accounts could require too much capital (to buy 1000 shares of SPY index for example you would need 400k in buying power, which is not well suitable for many beginner traders, but if one uses CFDs with 1:100 leverage, the capital required is much lower. The risk stays the same as long as one knows how to properly weight/size the positions, but capital/buying power requirements are much smaller. Or the other route to go about it is to use options, as those are much less capital/buying power-intensive as well.
Longing into crisis cycle (buying the crash)
Longing after the crisis cycle is statistically on average 6 months after the event start, is the ideal time window, historically, especially if the market has tanked over 20%.
Key data to keep in mind is the average % move of the crash and the amount of time it took to recover, this data could provide the trader with insight on when it might be time to start buying the equity market crash, and executing on long strategy (and stop shorting).
Perhaps one of the most robust indicators that should lead the trader on his actions and bias flip, and potentially one of the most difficult ones. Why? Because it is a natural reaction of the majority of market participants to be completely swallowed and consumed by the current crisis event, where they really start to believe that "this time is different". This time the recovery will not be as quick and the market will probably crash a lot more than it did historically. Yet in the majority of cases that does not happen, the data does not go out of the in-line behavior too much. It follows the pattern more or less. So this recency bias is what might prevent trader to really grasp the opportunity by horns and ride that reversal and bottoming within the crash as the recency bias just plays too much of a role to provide the trader with that side internal voice "Hey don't do it, this time is really different".
Another way to put the data above not into numbers but rather the chart is the image below. And it is not just the fact of how the correction of bear cycles perform that matter, but instead as well what happens outside of those cycles, as bullish cycles are just as important to extract as the potential crisis windows (which are much shorter often in duration but as well more volatile with more opportunities).
Get rid of oversimplified view on market bubbles
One of the major issues that many market participants have is that they find themselves too quickly in agreement with average Austrian economists and extreme marketeers in regards to when the market is in a potential bubble and when to stop investing or trading it on the long side.
It is an overblown topic, with a huge misleading spread by people in markets who have a very poor track record in terms of timing the moves well, for any serious trader using a mindset "eventually I will be right" is a self destructive behavior as the market will liquidate you out over a while if operating with such mentality while trading with leverage (even small leverage such as 1:4).
The reality is that in the 21st-century global equity markets are heavily stretched by the central bank's low rate policies across the whole globe and the share buybacks by many companies which skews the actual length to which the "bubble" of the stock market can really stretch. And this is by no means to be under-estimated.
As a macro trader of the US equities index one does not have the task to anticipate when the economic crisis is about to happen and to time it extremely well, while putting the whole focus into that area of anticipation. As a macro trader, you need a balanced view (realistic) that enables you to extract the edge out of any market cycle, whether it is the start of a new long term bull trend, the start of a bear trend, the middle of the bull trend, the later stage of so-called "bubble" etc. You need to be adaptive and most importantly operating within certain equations and views which allow you to do so.
Traders who see markets perpetually as Austrian economists do generally either get margin called by shorting bull markets day after day as the market is moving up and drying out the account. And while yes there are certainly many good points that the average Austrian economist will make, the issue is that they are often blind to the bullish side of market performance or to estimate if the market is even buy-worthy in the mid of the bull trend. And there are no personal grievances that I have against Austrians, it is just from my observations in years of macro it is that it is easy to notice that many traders and investors too easily fall prey to their oversimplified (and often non-realistic) view of the world, especially when it comes to pessimistic side ("crisis is just around the corner, any day now").
Another problem of the current era is very low-interest rates which pull the money out of saving accounts into more speculative markets or equity markets in general. Not just that there is the significant prop-up job being done from central banks buying the toxic assets or even shares of stocks (such as SNB) or the QEs but even the retail capital is pushed into higher % earnings from bank accounts towards equity markets, all of which can stretch the historical valuations a lot. This means that using past historical measures on how to define or detect bubble could be delayed with a lag because for example a P/E ratios under high-interest rates era such as the 70s could have a different impact on sucking the capital out of over-stretched equity market compared to the market today where the rates are at 0 (while interest rates in 70s were much higher) and capital has barely any other better area to go, but the equities for a decent return. All of which can sustain the bubbles a lot more and it requires trader or market analyst to be a lot more careful on how to identify the bubble.
Or I would place it in words such as, one has to use a lot more extreme definition of what a market bubble is because calling a bubble too early could be not just un-beneficial as one misses plenty of gains on the long side, but potentially dangerous if shorting against way too early.
Whatever the mathematical numbers one is inputting into the equation to define a bubble in the 50s or 80s, in my view due to interest rates, the central bank policies, now one needs to upper / lift those numbers quite a lot higher to define bubble better. Not to mention the easier access to markets from all over the globe which can create much stronger/bigger bubbles but as well sustain them for longer, especially if the bubble is slow at its growth.
One of the important variables that accurately defines the bubble is not the absolute numbers but rather the growth at which it is going. A 2000 .com bubble is a great example of a bubble at extremely high growth speed, and in my view, this is a must to define a real bubble in the current modern era.
Example of such being the crypto 2017 market, high speed growth within single year:
Note that while yes the equity index is climbing and is at all-time highs, the growth speed is by no means even slightly to be compared to crypto or 2000 .com, which is why the first is not a bubble, but the second two are.
Traders need to understand the volatility component, the speed at which the asset is moving / expanding. The most frequent mistake that many tend to make is they just see assets moving up consistently on daily basis such as the SP500 index, and then assume it's a bubble. If it goes up 3 months in a row it's a bubble. That is a very poor and completely oversimplified way of estimating market bubbles. If it was that easy to define market bubbles the trading would be extremely easy as there are hundreds of assets that fit such conditions, yet if one was the too short majority of those within a few month time span he would most likely get crushed. Markets have their own mechanism of rewarding or punishing those with realistic perceptions and those without, and playing on too simplistic definitions is often a way on how that is translated through.
My general rule when it comes to defining bubbles in equity markets in the first place is this, and this rule holds well solid historically:
-Focus on finding equity index bubbles in fast-growing emerging markets, not developed markets
-If seeking for a bubble in a developed market (EU / US / Japan) do not look for a broad market bubble, but instead a sector bubble, especially innovative sector (Electric vehicles for example, or innovative geometric engineering, cryptocurrencies etc). Broadly speaking it is far more likely for the bubble to develop in the emerging market country rather than the developed market because emerging markets have a lot more of a cold/hot relationship when it comes to capital inflows or outflows. Developed markets are far more consistent in inflows/outflows, while emerging markets once the boom era starts, the international capital starts to fly into stocks at 5 or some times even 10 times the previous speed (Asian tigers 90s), which creates that much more likely conditions to create a bubble.
Again revert to the point in the article above: The speed of the move matters, not just absolute price levels that the asset goes to. The more drastic the speed of capital inflows, and the stronger the speed of movement to the upside in the equity index the more likely it is for the bubble to set. Slowly chopping low volatile consistent pushing of equity markets and capital inflows are not the conditions one should be looking for to set a market bubble. Getting this right is an absolute must.
Another point is splitting the tickers within the SP500 or just the general broad market of the developed country into hot theme sectors versus steadier colder themes. In many cases within the developed market such as the US, there will be a microbubble created frequently, within a specific sector. Those will give often good long/short opportunities, which makes it important for a trader to split the tickers across the required themes well.
To keep it very basic, for bubble, the chart should reflect such behavior:
As noted before, it is not whether the chart is bullish or not, or if the ticker was moving up for "too long", what matters is the relationship of all the key variables, they need to be tuned just right for bubble territory to come into play.
Shorting SPY index during the crisis
The key focus of this article is on the long side of SPY, there will only be very brief mentioning of shorting, as that only consists of under 5% of total SPY trades from the personal side. Shorting SPY is more difficult than longing, especially if swinging short trades, due to the overall nature of SPYs performance (a slow choppier uptrend with severe but quick bearish pullbacks that are often quickly corrected is average behavior over long term).
The behavior of the index itself does not favor shorting because most bearish pullbacks tend to correct relatively quickly, giving the trader a very small time window under which one can join the mid-term bearish trend, and shorting high prices in can be difficult because statistically you are more likely to get run over than to get in favor, even though that RR might be decent. It is more likely for the bullish trend to keep chopping slowly higher rather than delivering deep bearish pullbacks very frequently. This makes any shorting approach more difficult in itself. It has nothing to do with personal fundamental beliefs, or any reasons that one might place into the market, it is the historical behavior of the index that points this out as a fact.
All of said above leads to the reason why personally I only short SPY when there is a major global bearish event present, and generally that means a financial crisis which can deliver sustained bearish pressure on global equity markets (1 month or more). Any other mild catalysts are therefore excluded.
Anything lesser of a scale is usually not strong enough to keep a weight on the market for long enough. This means that one has to patiently wait for such an event to start taking place, and there have to be significant indications for several days that lead the trader to the belief that this time it is for real, it is not just a "drill". The above is critical to understand, trading bearish events in the equity index are all about the realistic perception of when "this time it is for real" versus "it is just a media pomp / overblown and it will dry off quickly". A trader who over-reacts to what media feeds them and no proper historical insight or context will fall for every mine. Usually, those who have too extreme bearish views daily or too utopian views (been there, done that) on how the global markets work tend to over-blow every market micro event into the potential expectation of crisis. 90% of the time, it will not happen. So it is very important if one really is there not to just feed the fear into the social media for his own entertainment, but instead, to make some P/L of the crisis event, the nihilistic and realistic read on reality is absolutely important. To really know the difference when the event has a chance to spill over into proper crisis versus when it is just isolated micro-crisis will be the real difference between those who do make gains shorting bearish cycle of equity index versus those who essentially will be shorting up trending SPY trend into bearish corrections (and eventually getting a correction on every move).
Any micro event in the global market if stripped out of historical context could be interpreted as a doom scenario. Without the broad statistical context-anything is possible. Yet trading is not about possibilities, rather about probabilities.
Three examples to get the point across on differentiation of micro-events versus true large macro cascade events, and using statistical probabilities from historical context:
1. Proxy escalation:
Two ships of two neighbor countries with problematic relationships collide (Korea) and anyone stripping such an event out of context too much could start to project the worst to follow next. It did not happen. Now that does not mean that such collisions cannot lead to very drastic outcomes, the real question is all about odds, and the details. In how many cases will they lead to further escalation at the scale that it could drag global equities for at least a month to the downside? In less than 1 out of 10, or with other words under 5% chance. If one strips that statistical data out of context and keeps betting short too early on such micro event expecting crash to follow, the data suggests one will most likely end with overall end-of-samples negative performance, even if getting it one time right (because chances are you won't be around that one time as it might take 30 years to come to fruition for example).
2. Yields spike on political uncertainty:
Bond yields spike 5% overnight as the political landscape of the country shakes and the new forced elections loom (EU 2016ish). Many observers started to follow up with all sorts of doom scenarios across many of such EU countries in those two years, the reality is none of which had any major follow through. ECB stepped in to support the bond market, and the majority of newly elected govt was unable to execute on what the voters voted for, where the EU technocrats got their way instead.
Speaking from US equity market performance there also was not much follow-through to bearish side on either of those events. Even though that there was serious thesis expansion of potential EU breakup by many social media/market analysts/voters, none of which happened. It is another example of why it is easy to over-blow events out of proportion and betting on very bearish scenarios by shorting the equity market is far more unlikely than it seems if stripped out of context. I should add that most of the points are made for US markets, not EU equity markets since the article's focus is specifically on US equities (global spill-over).
3. Risk escalation:
Coronavirus cases rise by 30% in certain countries in October with the midpoint of the second virus wave. Many expected equity markets to crash with the same magnitude as they did in March, none of which came to fruition, if anything markets went higher. Again expecting a major selloff in the equity index just half a year after the major crash happened is not a realistic or statistically good idea, as it will not happen in more cases than it does. Another example of not placing the situation under the correct historical context can lead to an over-blowing event.
And with all said above it should be noted that this is no easy task at all, having a realistic view in markets on the macro side takes a lot of learning and experience, and as stated above it is far more difficult to get right compared to joining and participating on the bullish cycle of equity markets when the grass is green. For this reason, the article has a heavy focus on the longing bullish cycle rather than shorting bearish cycle, as in my view many traders can learn how to long bullish cycle well, while very few might get the shorting of bearish cycle right, let alone shorting of the bullish cycle.
If there was any personal advice to give, I would say to focus on the long side as much as you can if you are a beginner trader, you will learn a lot more than listening to extremists in the market who try to time the start of next financial crisis on daily basis. Many beginner traders get burned doing it the other way around, because for some reasons beginners just as young people are attracted to extremes more than to boring and steady up-trending projections of the market (call it rebelling spirit, greed for the larger move, or just naivety, whichever it does not matter). Learn to master the bullish cycle first, and then expand into trading of the bearish cycle. Start where you should start as a beginner equity trader, not the other way around.
This is a core outline of how to trade the SP500 / SPY index with a long approach on day to day basis. Either with intraday trading, swing trading, or ideally a combination of two, depending on the current market conditions and opportunities.
It is trader's task to research the behavior of index historically as only that will provide enough context for one to build a solid approach and foundation that will allow one to stick through it over a longer period of time. The right mentality of objectivity (long term SPY performance over 100 years) is needed as well, those with too pessimistic or bearish views of the equity market's future performance (for whatever reason) will likely be unable to build enough firm conviction to participate with the approach outlined in the article above. Trading consistently long exposure approach on SPY requires a decent belief (rooted in reality and history) that equity markets and the productive force of the economy (plus 0% interest rates era with central bank liquidity propping) should eventually push the equity markets higher on a year to year basis. Without this basic premise and belief, any of the above content will not really matter at all, as this is the foundational piece from which to expand from.