‘Buy The Dip’ Giving Way To Market Capitulation

In this article:

• Hope fades into market capitulation
• Technical analysis guides traders
• This sector is an example to watch

Bulls still clinging to the “buy the dip” trading strategy are playing a dangerous game in a bearish market.

Emphasis on “bear-ish” when the market continues to trend downward and cries of deeper losses across the market are growing louder and more profound. This is a bear market to be reckoned with from a trader’s perspective.

Tracking the trend in this ongoing chop fest has been difficult as traders continue to struggle with finding solid entries to the downside.

To find trade opportunities in this market setting up for capitulation, Simpler’s traders rely on “top down analysis.”

‘Buy The Dip’ faces market capitulation

Hope makes this market dangerous.

Investors and traders are still hopeful this market will turn around. Many still cling to the “buy the dip” strategy. Buying in a bear market is much different than a dip in a bullish trend.

Traders buying and trying to ride a rally are getting hopes dashed. What seems safe quickly goes badly for the trader.

This pattern creates frustration and at some point as the market craters it will likely cause capitulation. This generally means that investors and traders stop resisting the selling pressure and give up on hopes of recovering losses as stock prices continue to decline.  

The danger comes from traders who remain hopeful, and thus drag out capitulation. Expectations are that when everyone throws in the towel, the market can start working up from the bottom.

All three major indexes are down for the year – Dow 15%, S&P 18.7%, Nasdaq 28%. The Nasdaq flirted with a positive gain throughout the session Thursday before closing lower.

The Dow closed at 31,253.13 points to fall .75 % (dropping 236.94 points on the day). The Nasdaq slipped to 11,388.50 points for a .26% slip while the S&P 500 fell .59% to 3,900.72 points.

How low will the market have to go before capitulation?

Only time – and looking back at the charts – will reveal when this market hits a true bottom.

Drill into market with technical analysis

Simpler’s traders have found success navigating this market by planning trades using a “sector first” approach followed by drilling down into individual stocks.

This follows the Simpler Trading foundation of using top down technical analysis to shut off the “noise of news” and follow what the charts are revealing.

Our traders work through this analysis to identify potential trades in this market.

In this example, start with the home builders sector. This sector encompasses construction companies involved in manufacturing residential homes.

From the top – the sector – look at the iShares U.S. Home Construction ETF (exchange traded fund). The ticker symbol for this is ITB. This ETF focuses on tickers for domestic home construction stocks and retailers for home improvement products.

This week ITB hit a new 52-week low and Simpler’s traders see this as holding a bearish pattern. The focus is watching for a squeeze – indicating a possible directional move – on the chart. This squeeze build-up is supported by looking at the top tickers within the ETF all showing similar squeezes.

When these sector elements are aligned like this the expectation is for a directional move ahead.

Drilling down further, individual stocks in the ETF such as Pultegroup (PHM), Lowe’s (LOW), and Home Depot (HD) have seen lower price action.

An important part of this example is traders must be prepared to tolerate a move back up into the 21-day exponential moving average (EMA) leading into the summer. This means also watching for the 21 EMA to continue as resistance to price action.

Rally didn’t kill bearish movement

In the strategy example above, traders would watch for price to take out the previous low and move into the 1,272 Fibonacci extension. The ideal scenario would be a signal from the squeeze of a directional move.

Any trades following this example playing out over weeks would require tolerating the “heat” in this idea. Movement up toward the 21 EMA – the heat – is likely before price continues as expected on a bearish path.

The risk in this example can be understood by taking a look at the SPDR S&P 500 ETF Trust (SPY) from last Friday.

Charts showed a short squeeze, similar to the ITB example, building until all three major indexes ripped higher. Short squeezes failed, and the market closed higher on the day.

But the rally didn’t eliminate the bearish movement in the market, as evidenced by significant gaps downward this week.

Keep in mind that the S&P 500 has barely managed to “stay” in correction territory without officially transitioning into a bear market. A bear market is when the S&P 500 loses 20 percent over two months.

This continued downtrending environment is the focus of Simpler’s traders going forward.

The S&P 500 is down 2.49% over the last five sessions (this includes the rally last Friday) and down 8.15% in the last month. It has dropped from 4,796.56 to start 2022 to its latest close at 3,900.78 – over 18% in losses.

This is a tough market to trade, and recent freefalls across the board have damaged the structure of the market.

Adapting to what the market reveals

As mentioned previously in Simpler Insights, experienced traders have adapted by trading on tighter time frames. Traders who focused on a directional, income-focused setups over weeks or months have switched gears for setups covering hours or days with limited trades extending beyond a few days.

A shorter time frame can help manage risk by limiting exposure to sudden shifts against a trade position. This market has proven reactive to Federal Reserve, economy, political, and inflation news.

“Trade the market you’re in, not the market you wish you were in” is not a catch phrase. Traders must adapt to this bear market environment which is not directional, not trending, and susceptible to outside pressures.

As mentioned earlier regarding the home builder sector, the housing market appears to be slowing down. As home building slows, this affects jobs in construction, mortgages, banking, retail, etc. These factors could be a snowball gathering steam into the summer months, and beyond.

This opens the door to arguments that a recession is on the way if not already in play.

Economic data signaling a recession looks “in the rear view mirror” to determine an actual recession. The designation is based on data from previous quarters.

This creates fear among market participants – investors and traders – which in turn leads to sudden, harsh swings in price movement.

Fear in the trading world has spiked with the Volatility Index (VIX) remaining high. The VIX – or fear index – was at 29.34 at the close on Thursday. (Early in the session the VIX jumped to 32.61 before declining.)

Traders are constantly studying how to trade this messy market with potential for income.

Simpler’s traders expect this market to continue moving down. This is indicated by indexes, sectors, and individual stocks. The market is in a persistent weak state.

The Simpler Trading goal remains (it sounds like a broken record) to follow the charts, identify setups with potential, and to take trades that manage risk against limited capital exposure.

Short rallies offer little hope for bulls

The market can still spike higher – like last Friday – but this doesn’t mean a change in the push downward. For any spikes, Simpler’s traders will consider working the short side as the rally fails.

There are no guarantees in trading, so in a year or two everyone may look back at this period in the market and say, “Wow, that was the best buy-in opportunity missed.”

Simpler’s traders feel that is a “good miss” considering the risk at hand where the market may not be anywhere near a true bottom.

Where there is smoke, there is fire, and this market is smoldering hot to the downside.

Taking this cautious, “follow the market’s lead” strategy has worked for many of Simpler’s traders. Wins this year – certainly losses mixed in – haven’t been easy. The focus has been taking trades with strong potential and riding out the nail-biting sessions along the way.

Some setups that have worked for traders have been butterflies and condors.

Limiting risk over shorter time frames has meant risking several hundred dollars in capital for the potential to make several thousand dollars if the trade maximizes 100% potential. This also means taking profits before a winning trade hits the maximum goals.

Taking a 50% gain in this example is a positive win versus staying in the trade too long and risking a market shift that wipes out gains.

This market isn’t giving traders much time to work a trade, so our team avoids long-term exposure to this volatility.