The 8 Step Guide To Trading Stock Market Corrections Successfully

Stock market corrections are hard to predict and can often times hit traders hard. The recent bull market has seen a few corrections and each has wiped away profits in a matter of days. Corrections are said to adjust equity prices back down to their actual value or support levels.

In reality, prices go down because of speculator reactions to either expectations of news, reactions to actual news, and/or investor profit taking after a long run. And here lies the reasons why the come out of now where! We never know how big the next one will be or when it will come.

Here is my list of 8 things that will help guide you through the next correction successfully:

 

1. Asset Allocation - each week you should revisit your current asset and trade allocation. Where can you look to reduce risk and downside exposure should something bad happen. Don't exit trades completely though as that would be an attempt to time the market, which is (rather obviously) impossible.

2. Look For An Entry - Wait Kirk!?! I thought we were talking about corrections? Well, if you never plan your entry before it happens then how are you going to make money right. There has never been a correction that has not proven to be a buying opportunity, so start looking for support areas where you could buy. I start like to use the VIX as my main indicator and market extremes.

3. Buy Cheap Protection - Don't hoard all the cash you accumulated during the rally. Use some of the profits and buy some put protection or create back ratio spreads. Do something for goodness sack to hedge yourself. There are no crystal balls, and no place for hindsight in an investment strategy especially when it comes to options.

4. The Rally Will End - This is one that I wish more people would understand. Investor confidence broaden with each new realized gain on the way up. But the more the herd mentality shifts to bullish, the harder and faster things will fall. Don't get hypnotized by this rally

5. Buy Slowly On The Way Down - The start of long corrections be violent, but the trading afterwards could continue much lower for months. Notice the correction the market had after the "flash crash" which seems huge - but was only a blip in the bigger picture. Buy more slowly as opposed to more quickly, and establish new positions incompletely. Hope for a short and steep decline, but prepare for a long one.

6. Follow Buffett's Wisdom - One thing I always remember is the famous Warren Buffett quote. It will always be a great guiding light when determining whether to get into or out of a trend...

When everyone is greedy, I want to be fearful. And when everyone is fearful, I want to be greedy.

7. Use Option Selling - There's no reason to wait for something to happen in any market. With options you can sell puts below the market or sell calls above the market and profit from slow and steady markets. Don't force the market to make a move you "want" it to make. Trade away from the market and stay safe but make some money.

8. Look For Divergence -  There are a lot of great subtle clues that technical analysis gives us. MACD, Stochastics, RSI all can show divergence right before a top (or bottom form). The declining momentum with increasing prices shows extreme weakness. Notice these early.

What Do You Hate Most About Corrections?

To a certain extend we all hate corrections. If you are long you might get killed and if you are short you might exit too early. Add your comments below and blow off some steam about what you hate most about the "correction" process.