The month of August has been a brutal one for the stock market. The NASDAQ has already dropped more than 15% since August 1st.
But, if you’ve been following my newsletter, you know that we’ve actually been making big profits off of this Downtrend. NOT by shorting individual stocks, but by investing in inverse ETFs.
On August 1st, the Darvas System triggered a Downtrend signal. At that time, I bought into SQQQ, an ETF that tracks the INVERSE of the NASDAQ at 300%. That is, if the NASDAQ goes down 10%, SQQQ goes up 30%.
Needless to say, in a strong Downtrend like the one we’re experiencing, you can make BIG money with this type of strategy.
But the question I’m often asked is, why use inverse ETFs to “short” the market? Why not just short individual stocks?
Here’s why an inverse ETF is the IDEAL way to make big money when the market goes into a Downtrend.
Most market Downtrends last 6-12 weeks; some shorter, some significantly longer. The NASDAQ’s “typical” decline during most Downtrends is 15%-25%. Some historic Downtrends are much more severe than that, but in general, you can expect to see the market decline about 20% during a typical market correction.
Now let’s compare this to individual stocks. The best stocks to short during a Downtrend are the former leaders that rose the highest during the previous Uptrend. This makes logical sense. The higher they climbed, the further and faster they are likely to fall when the selling begins. It’s not uncommon to see stocks that climbed 50%-100% during the Uptrend fall 40%-60%, from top to bottom, in a Downtrend.
But, successfully shorting individual stocks is one of the most difficult techniques for a trader to master. Even history’s very best traders had difficulty consistently making money by shorting individual stocks in a Downtrend. That includes Nicolas Darvas himself, as well as his most famous students.
The reason it’s so difficult to consistently succeed at shorting individual stocks is because of the extreme choppiness that occurs during a former leader’s fall. The method that worked so well on the way up – buying breakouts – doesn’t work very well at all on the way down – shorting breakdowns.
You can’t simply reverse the process (trading breakdowns the way you normally trade breakouts) because the emotional forces that drive the market have been reversed.
Greed and optimism drive a stock higher while fear and pessimism drive a stock lower. The buyer’s emotions that make a stock rise (“I’ve got to buy into this hot stock, everyone else is doing it and I don’t want to miss out on any more gains”) are completely contrary to the seller’s emotions that make a stock fall (“I’ve got to get out of this stock, but wait, surely it will soon bounce higher, maybe I should actually buy more, no maybe I should sell some here and the rest on the first bounce, no maybe…”).
The emotions of greed and fear create much different investment behavior. They aren’t simply the flip-side of each other in terms of the technical action they produce.
Plus, when it comes to a stock’s downslide, you also have to deal with erratic bounces caused by short-sellers exiting the stock on the way down. Every time a hedge fund that was short the stock wants to take profits and exit a position, they must “buy to cover” the position, which creates a sudden surge higher. This short covering triggers other buys and creates many aggressive bounces higher as a stock declines over the long run.
It’s not uncommon to see a stock break down through a key support level, fall 10%, then bounce 15% higher in just two or three sessions, before falling another 10%, and repeating the process. It’s your classic “one step up, two steps back” scenario all the way down.
This is exactly why more than a few brilliant traders have decided not to mess with shorting stocks at all.
However, there is a much better way to make big money when the market enters a Downtrend and that is our preferred method of buying an inverse ETF.
First off, the overall market is much less erratic than individual, high-beta growth stocks. While whipsaws and choppy behavior obviously occur in a market index, the aggressive nature of such swings is less severe and much more manageable in a portfolio.
Secondly, and more importantly, we don’t base this ETF trade on a technical breakdown of the index as much as we trade it based on simple Distribution Day versus Accumulation Day behavior. This method has been proven as a much more accurate way to determine the general market’s trend. By using an inverse ETF, we can easily profit from this trend.
And finally, let’s look at the potential gains of this inverse ETF method versus the potential gains of shorting individual stocks.
Again, a former leading stock can often fall 40% or so during a Downtrend. The NASDAQ itself is likely to fall 20% in a typical Downtrend. If we use an ETF such as QID, which is designed to represent 200% of the inverse of the NASDAQ, we stand to gain the same 40% as we would if we timed our short on an individual stock just right. Or, if you wanted to use a more aggressive inverse ETF, such as SQQQ, which represents 300% of the NASDAQ’s inverse, you’d be looking to gain 60%.
The best part is, these gains would be made using a trading technique that is much simpler and less erratic than trying to short an individual high-beta stock.
With this in mind, the best action to take during a market Downturn is to profit from it with this inverse ETF method and then spend the rest of your time eyeing stocks that are building new bases and preparing to break out when the Uptrend resumes. (Remember, you never know how short-lived a Downtrend may end up being.)