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An Old Wall Street saying points out that investors should not “Confuse brains with a bull market.” In other words, don’t get overly cocky when the market moves higher, as most stocks move higher with it. However, even in the strongest of markets, unforeseen gap down days can cause investors to make poor decisions in the heat of the moment. Below are 4 ways to deal with a gap down market:
Amateur Hour
Particularly on gap-down openings, I refer to the first hour of trading as “amateur hour.” I call it amateur hour because during a gap down opening, inexperienced investors often “puke” out their positions. More often than not, the stock that was panic sold ends up higher in the session. Even if you plan to exit a position, nine times out of ten, it is best to give it an hour, and ideally, until the close. The importance of daily closes far supersedes the opening print.
Image Source: TradingView
Pictured: The opening print often marks the low of the session.
Average Cost
Unfortunately, no stock or market goes straight up, and several times throughout the year, there will be “tape bombs” or unexpected pieces of news that knock down the market. How can an investor know whether to hold a position through a gap down? The honest truth is that you never know for sure and that investing is a game of odds. However, the nuanced answer is that you should be more lenient with positions you have a cushion on. For example, if you purchased a stock at $100 and it goes to $120, you’re up 20%. If it gaps down by $10 or $15, you still have a profit and are playing with “house money”. Conversely, it’s time to play defense if you own a stock at $100 and it immediately gaps down to $80. In this case, you have not earned the right to hold. In the hypothetical IonQ ((IONQ - Free Report) ) example below, those who bought at point A have more leeway than those who bought at point B.
Image Source: TradingView
Scan for Relative Strength
New, inexperienced investors will focus on licking their wounds or may ignore the market on brutal down days. Nevertheless, green days are less useful because on green days, most stocks follow the market direction higher, and not much information can be gained by an investor. However, a bright red down session is precisely when investors can find the best ideas because they stick out like a sore thumb.
Relative strength simply means that relative to a benchmark (typically the S&P 500), the stock is resilient (down less or even green for the day). Often, once the market pressure is relieved, the stocks with the most robust relative strength on the market downside continue to lead to the upside.
Understand that relative strength can be utilized in all time frames by investors. Below is an example of relative strength from earlier this year. In the box on the chart, notice how E.L.F Beauty ((ELF - Free Report) ) diverges from the S&P 500 Index and makes new highs, while the S&P lags and makes new lows – clearly a sign of relative strength in ELF. Finally, sure enough, as soon as the market regained its footing, ELF became a market leader and never looked back.
Image Source: Zacks Investment Research
In early trading Thursday, names exhibiting relative strength included Coinbase ((COIN - Free Report) ), Amazon ((AMZN - Free Report) ), Meta Platforms ((META - Free Report) ), and Eli Lilly ((LLY - Free Report) ) (all green in a red tape).
Get Off Margin
Few investors have had the longevity of Warren Buffett and long-time partner Charlie Munger. When discussing the three ways to go broke, Munger half-jokingly said, “There are three ways to go broke – liquor, ladies, and leverage.” Never overextend yourself, especially in a volatile market. Leverage can amplify P&L swings and be detrimental to your decision-making.
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4 Expert Tips for Navigating a Gap Down Market
An Old Wall Street saying points out that investors should not “Confuse brains with a bull market.” In other words, don’t get overly cocky when the market moves higher, as most stocks move higher with it. However, even in the strongest of markets, unforeseen gap down days can cause investors to make poor decisions in the heat of the moment. Below are 4 ways to deal with a gap down market:
Amateur Hour
Particularly on gap-down openings, I refer to the first hour of trading as “amateur hour.” I call it amateur hour because during a gap down opening, inexperienced investors often “puke” out their positions. More often than not, the stock that was panic sold ends up higher in the session. Even if you plan to exit a position, nine times out of ten, it is best to give it an hour, and ideally, until the close. The importance of daily closes far supersedes the opening print.
Image Source: TradingView
Pictured: The opening print often marks the low of the session.
Average Cost
Unfortunately, no stock or market goes straight up, and several times throughout the year, there will be “tape bombs” or unexpected pieces of news that knock down the market. How can an investor know whether to hold a position through a gap down? The honest truth is that you never know for sure and that investing is a game of odds. However, the nuanced answer is that you should be more lenient with positions you have a cushion on. For example, if you purchased a stock at $100 and it goes to $120, you’re up 20%. If it gaps down by $10 or $15, you still have a profit and are playing with “house money”. Conversely, it’s time to play defense if you own a stock at $100 and it immediately gaps down to $80. In this case, you have not earned the right to hold. In the hypothetical IonQ ((IONQ - Free Report) ) example below, those who bought at point A have more leeway than those who bought at point B.
Image Source: TradingView
Scan for Relative Strength
New, inexperienced investors will focus on licking their wounds or may ignore the market on brutal down days. Nevertheless, green days are less useful because on green days, most stocks follow the market direction higher, and not much information can be gained by an investor. However, a bright red down session is precisely when investors can find the best ideas because they stick out like a sore thumb.
Relative strength simply means that relative to a benchmark (typically the S&P 500), the stock is resilient (down less or even green for the day). Often, once the market pressure is relieved, the stocks with the most robust relative strength on the market downside continue to lead to the upside.
Understand that relative strength can be utilized in all time frames by investors. Below is an example of relative strength from earlier this year. In the box on the chart, notice how E.L.F Beauty ((ELF - Free Report) ) diverges from the S&P 500 Index and makes new highs, while the S&P lags and makes new lows – clearly a sign of relative strength in ELF. Finally, sure enough, as soon as the market regained its footing, ELF became a market leader and never looked back.
Image Source: Zacks Investment Research
In early trading Thursday, names exhibiting relative strength included Coinbase ((COIN - Free Report) ), Amazon ((AMZN - Free Report) ), Meta Platforms ((META - Free Report) ), and Eli Lilly ((LLY - Free Report) ) (all green in a red tape).
Get Off Margin
Few investors have had the longevity of Warren Buffett and long-time partner Charlie Munger. When discussing the three ways to go broke, Munger half-jokingly said, “There are three ways to go broke – liquor, ladies, and leverage.” Never overextend yourself, especially in a volatile market. Leverage can amplify P&L swings and be detrimental to your decision-making.