Profit Stop Example Using ProShares Ultra Dow30 (ETF) (NYSEARCA:DDM)
There are massive risks in a market that moves in one direction, there are also massive risks in markets that have light volume, and the action over the past two weeks has had both. This article explains where investors should set their profit stops so in case this rally stalls and the market begins to collapse the gap-down risk can be minimized.
Over the past 1.5 weeks the SPDR S&P 500 ETF Trust (NYSEARCA:SPY), SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA), iShares Russell 2000 Index (ETF) (NYSEARCA:IWM), PowerShares QQQ Trust, Series 1 (ETF) (NASDAQ:QQQ have all moved in lock step, in one direction, straight up. Some people have argued that these increases were driven by computer trading programs, others have argued that the smaller investor was putting money to work and larger investors were stepping back and not selling into the strength, but regardless of who was putting money to work and regardless of why, when the market increased we do know that it also increased on very light volume.
Therefore, the market has not only been one sided as it moved straight up, but it has done so on very light volume, and that increases the risks that would otherwise exist simply do to a market that move straight up like this one.
When markets move in one direction without backing and filling along the way gaps are created, and the bigger the move in the market the bigger the gaps become. The gaps usually begin where the one-sided market move begins, and they usually end when the support lines of the one-sided channel that developed thereafter break. It is very rare to see a market move in one direction without retracing, and it is even rarer to see a market that has moved in one direction with such light volume continue to move higher without retracing.
This suggests that the probability of a retracement in these markets is high, but it will require a break before it happens. Thus far, the break as not occurred, the market continues on its one-sided path, and smaller investors are as giddy as I have ever seen them, but complacency is dangerous.
If this light volume rally turns and the trend lines begin to break the gap between current market levels and the beginning of this one-sided market move could be very devastating to those smaller investors who believe that the market will go straight up forever.
So how do we protect ourselves?
Here is an example taken directly from our Strategic Plan strategy. Our Strategic Plan strategy is designed to trade around important inflection points in the longer term trends of the market. It focuses on the Dow Jones industrial average, and when the Dow Jones industrial average fell to test 16,400 a week or so ago the strategy triggered a buy signal telling followers to buy ProShares Ultra Dow30 (ETF) (NYSEARCA:DDM). This turned out to be the beginning of the one-sided market move.
The Strategic Plan strategy is holding about 6% in gains over that very short time frame, and given the gap down risk that exists we have initiated a profit stop based on the action in the Dow Jones industrial average. Specifically, if the Dow Jones industrial average breaks below 17,065 Strategic Plan followers have been instructed to secure gains.
In addition, this profit stop has been suggested to investors who are holding other positions that were initiated in line with this strategy, without using the same ETF.
This example can help everyone protect their gains and identify a reversal trigger before it happens. If the market continues to move up we will also increase our profit stop, but maybe not proportionally. If it falls we will secure gains and wait for the next trigger. The Strategic Plan Strategy has already secured 14% in gains YTD and it did not make a trade between March and July.