The Best Way to Profit from a Downtrend

by Darrin Donnelly on August 23, 2011

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.)

* You can follow the Darvas System – with EXACT buy and sell points – by clicking here and downloading Darvas Trader PRO.

 

{ 6 comments… read them below or add one }

Zikai August 23, 2011 at 4:48 pm

Hi,

I too have been shorting this market with leveraged bear market funds. I have noticed that it is impossible to achieve the full 3 X 20% = 60%. Here is why. The market normally pulls back 5% by the time that you realize that a correction/bear market is imminent. if you use O’Neil’s “follow thru day” as rally confirmation, the market may bounce off the bottom by another 5% or so before it is clear that a rally resumes. So you are basically shaving 10% off a typical 20% correction. Your profit will shrink to 3 X 10% or 30%. 30% profit is not bad…except that not every 5% pullback leads to 20% correction. One is likely to be whipsawed and give back a large part of the profits. Tight stop losses are advisable.

Thanks

Reply

Darrin Donnelly August 23, 2011 at 9:33 pm

Hi Zikai,

Be careful getting too focussed on trying to grab the absolute top and absolute bottom of any trend. This has been the downfall of many traders. Instead, focus on grabbing the bulk of a strong trend. That’s where the big money is made.

Also, I’m a big proponent of using a tight INITIAL stop, but you want to make sure you give your trade some breathing room along the way. Every strong trend – up or down – will have several pullbacks or bounces along the way. You don’t want to keep your stop so tight that you get shaken out of a winning trade.

– Darrin

Reply

Zikai August 24, 2011 at 11:33 am

Hi again,

Yes, trend followers do not guess the top and bottom of a trend, which is also the reason that profits on the short side are limited in mild corrections.

Do you trade around SQQQ, taking profits at logical support and resistance levels?

Reply

Darrin Donnelly August 24, 2011 at 2:03 pm

Hi Zikai,

I have to reserve the specifics of my trades for my subscribers at http://www.darvastraderpro.com

But, I can tell you that a trade like SQQQ has already offered us two good entry points and will likely provide us with more if the Downtrend continues.

– Darrin

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Joe Fuika August 26, 2011 at 5:24 pm

Very very good post

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Darrin Donnelly August 26, 2011 at 5:27 pm

Thanks Joe, I really appreciate it!

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