Going against the trend can be dangerous in a bear market.
One of the most important elements in any trading strategy is the exit method. There must be a point at which he cuts losses or books profits. How he does this is much more critical than any skill in choosing the right contracts to trade.
A good trading strategy will minimise losses while maximising gains. So, any exit method must find a balance between the need to control losses and the need to squeeze gains from a winning position. This is especially true in choppy situations, where it is hard to be consistently right, or to make enough from winners to overcompensate for losers.
Most successful traders seek to identify trends and trend reversal signals. When they can identify a trend, they jump in. Most trending systems are backed up with stop losses that ensure the trader can exit with minimal losses if the signal is false or the trend reverses.
There are many systems of identifying trends, ranging from extremely data-intensive algorithms to vanilla rules of thumbs such as "three successive sessions of gains" . There are also many methods of calculating and setting stop losses. Broadly all these are designed to do the same thing: Identify a trend, ride the trend, use a stop loss to exit for minimal losses if the initial trade is wrong. Nothing works consistently if there is no stable trend.
The importance of liquidity increases in choppy situations because the chances of any trading system throwing up false signals is higher. The worst kind of losses occur in illiquid, choppy stocks. Suppose an illiquid stock hits an upper circuit and triggers a buy signal and the trader enters. Now, in the next session, the stock reverses direction and hits a lower circuit. The trader is stuck with a loss that cannot even be booked!
One advantage to staying inside the universe of the highly traded F&O list is that there are no circuit breakers and there is a lot of liquidity. Therefore, there is a guarantee that an exit will always be available. Another advantage to playing F&O is of course, the ability to short easily.
The over-riding importance of liquidity is one reason why TV programmes about the stock market can be misleading, or actively dangerous, in choppy situations. Traders who blindly target TV recommendations often suffer losses due to a disconnect between the thought processes of the analysts and the target audience.
TV frequently highlights small stocks that are only available in the cash segment. These can be bought against delivery but they can only be short-sold intra-day.
Quite often, such stocks are fundamental picks suggested by an analyst thinking in terms of long-term investments, based on attractive valuations or growth prospects. It is also true that in an up-trending market, smaller stocks will frequently outperform larger ones, if only due to base effects.
Unfortunately, the target audience for most TV programs consists of short-term retail traders, working on margin or borrowed capital. They are looking for profits within a few sessions. If they get stuck in a small stock with a choppy trend, the losses can be catastrophic.
Small stocks are often worth buying for the long-term. They are worth trading only in a few specific circumstances. One is when big stocks are also doing well - that is, a full-fledged bull market.
In a major bull market, liquidity is good even in smaller stocks and uptrends are easier to discern and tend to last longer. The other situations when small stocks work are specifically news-based but then, the trader must have the ability to digest the information and act on it appropriately. In situations, when smaller stocks are moving up but larger stocks are not, buying small stocks can be especially dangerous. Heavyweight stocks are backed by institutional money and when the heavyweights are doing badly, the smart money is bearish.
Small stocks, on the other hand, are more often backed by retail traders and a bull market in small caps indicates retail is bullish.
It is very rare, or almost unheard of, for a sustained bull market to develop in smaller stocks while bigger stocks are moving South. In other words, when the smart money is bearish and the retail trade is bullish, the smart money is usually correct.
An analyst might recommend any given stock. It is up to the trader to see if it can be profitably traded in his preferred manner for his preferred timeframe. Small stocks fit trading criteria quite rarely because exits are often very tricky.
