The 5 Rules of Stock Trading in a “No Buy Zone”

by Darrin Donnelly on December 1, 2010

Click on chart to enlarge.

Click on chart to enlarge.

Perhaps you’re familiar with the military phrase: “no fly zone.”  It indicates an area in the sky where foreign aircraft are not allowed to fly through.  If they violate this “no fly zone,” they run the risk of being immediately shot down and destroyed.

Well, the stock market has a version of this called the “no buy zone” and it occurs when the overall market is under pressure.  If you buy stocks in a “no buy zone,” you run the risk of seeing those stocks shot down quickly, thus destroying your portfolio.

On Tuesday, November 16th, as reported in Darvas Trader PRO, the stock market officially entered a “no buy zone.” 

This happened when the NASDAQ logged its fifth distribution day in less than one month.  A “distribution day” occurs when the market declines (or “churns”) on increased volume.

Five distribution days over a short period of time signals that the stock market is under pressure and entering a downtrend.  (Note the arrows marking each distribution day on the chart that accompanies this article.)

As Darvas traders, we also refer to a down-trending market as a “Stage 4” market.

Whatever you call it, it means the market is trending lower and no new purchases should be made under such conditions.

A Stage 4 market can often be quite constructive as it allows the broad market to rest up and it allows leading Darvas stocks to form new bases. 

Entering a Stage 4 doesn’t necessarily mean you should sell all of your positions.  Rather, it simply means that we’ve recognized a change in market direction.  This downward trend puts pressure on all stocks and therefore makes buying new stocks way too risky.

In a Stage 4 market, you want to make sure you get off margin.  This may mean selling a few full positions and/or selling portions of a few winning positions to lock in profits.  We want to decrease our risk during this stage and being on margin is way too risky right now.

Obviously, regardless of what stage the market is in, you want to immediately sell positions that hit your stops.  There is no exception to this rule and during a Stage 4 market, it’s even more important to follow this practice.  

When the market sells off rapidly, it can be tempting to convince yourself that a bounce higher is due.  The amateur trader says to himself, “I’ll wait for the bounce and once we have a day where my stock is up 2% or so, that’s when I’ll sell.” 

Do NOT make this mistake.  The bounce you’re waiting for often doesn’t come until your stock has fallen another 5%, 10%, or even more. 

As trend traders, we’re not trying to predict what the market will do next; all we’re trying to do is correctly identify and then ride the current trend. 

Wishing and hoping for the trend to change is a recipe for losing big money.  You simply can’t fight the trend.  If a stop is hit, exit the position fully with no questions asked.

I should also point out that the beginning of a Stage 4 market is not the time to start shorting.   As Darvas traders, we are prepared to make money shorting during a downtrend, but it’s too early to start shorting right now.  Only when former leading stocks start building bases below the 50-day moving average line will we start to make short trades.  These opportunities usually won’t show up for at least a month or two into a new downtrend.

The thing about Stage 4 market corrections is that you never know how severe they will be or how long they will last.  For all we know, we might have already notched our lows for this correction.  On the other end of the spectrum, we might be settling in for a downtrend that lasts a couple months or more. 

The point is, we could be back in a buying mode in a week or two or we could be making money on the short side in a month or two.  Don’t try to predict the market, just ride the trend.

To sum up, in a Stage 4 market, you need to follow these 5 rules:

1) If you’re on margin, get off it.

2) If you’re still holding full positions that have gone up 20% or more, consider selling a portion of those positions to lock in some profit.

3) Trust your stops!  If a stop is hit, exit the trade immediately without second guessing or trying to “predict” a better exit.

4) If your stock holds up above key support levels, there’s no reason to sell it (assuming you’ve already followed points No. 1 and No. 2).  Don’t panic.  Let your stock build a new base. 

5) Don’t buy into new positions or add on to currently-held positions.

Remember, the market can turn quickly.  Some Stage 4 corrections are over and done with in a matter of days.  Others last several months.  Stay tuned to Darvas Trader PRO for the latest market health reports and then simply trade with the trend.
 
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* Portions of this article appeared in Darvas Trader PRO.  You can try Darvas Trader PRO risk-free for 30 days by clicking here.

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