Lessons Learned Trading a Bear Market Part I: Coronavirus 2020
This is part one of a multi-part series documenting some of the events that have unfolded during the 2020 coronavirus (COVID-19) outbreak and the lessons and takeaways I’ve learned trading along the way. We start off with a little context of how we got to this point so that this article might prove useful years down the road to traders who have never experienced these types of environments and the ways in which they can potentially unfold.
How the bear market started
2020 started off as a very quiet and uneventful year for the stock market following strong double-digit gains in the major averages in 2019. Stocks were trading at all-time highs, trends were up, momentum steady, and the volatility index VIX traded right around 12.
Everything was on track for higher prices, until the end of February when everything was completely turned upside down.
A new, highly contagious coronavirus (COVID-19) was discovered in Wuhan City, Hubei Province, China. Markets initially shrugged this off as a no-big-deal isolated event until the spread of the virus accelerated throughout China — and soon worldwide — killing over ten thousand and hospitalizing and infecting hundreds of thousands of others (numbers as of March 23, 2020).
It’s a tragic event for society and one that affects virtually every single person — even you reading this article in some way or another. We sympathize for everyone who has been, or knows someone, inflicted by the virus, all the way down to the small business owners and service workers who are facing extreme financial hardship as a result. It’s a horrible situation that is bigger than financial markets, but because Trade Risk specializes in trading education, we’re going to do our part to share how to prepare for events like this in the future and hopefully mitigate their impact on your money.
For those of you who want an “in the moment” feel for the price action at that time, watch the following market videos from our YouTube channel:
- Week 1 – The initial 11% drop
- Week 2 – Inside week – the calm before the storm
- Week 3 – Acceleration lower 9.5% drop
- Week 4 – Panic and the largest drop yet down 15%
For the brief version, here are a few tweets that capture the broad strokes of the events as they unfolded:
Nearly a 20% correction in 14 trading days for the $SPY as the market prices in a growing list of uncertainties. We break down all the action in today's market recap video https://t.co/cq8UUhOQCX $SPY $IWM $QQQ $TLT $USO & more #Stocks #Trading pic.twitter.com/eZpizld1Gp
— Evan Medeiros (@EvanMedeiros) March 10, 2020
Here’s what the Dow Jones monthly chart looked like on March 12, 2020:
What a savage Dow Jones monthly chart. Throwback to 2017 levels in a few short weeks. Risk happens fast. $DJIA $DIA pic.twitter.com/JUXwtY2gJp
— Evan Medeiros (@EvanMedeiros) March 12, 2020
And the extreme action we saw in the credit markets, which really was one of the most concerning aspects of this meltdown:
Many bond funds showing signs of stress today, Vanguards $BND trading like a low liquidity Russell 2000 stock at the open. pic.twitter.com/6DvkKSlaMF
— Evan Medeiros (@EvanMedeiros) March 12, 2020
Overnight limit down futures trading became an ordinary occurrence:
Time to gear up for another busy week as futures trade limit down again. We covered all of the technical levels, risks, and scenarios to keep an open mind about looking ahead in our weekend market recap: https://t.co/CnUrZdA6Va $SPY $TLT $GLD $USO #Stocks #Trading pic.twitter.com/oKoPry88hU
— Evan Medeiros (@EvanMedeiros) March 15, 2020
Finally, a look at some sector performance after 18 days of trading that would be disastrous for full-year returns, let alone just a few weeks:
Here's the sector performance return profile since the correction high just 18 days ago. $XLE takes the cake down nearly 50%, meanwhile consumer defensive $XLP trying to stay true to its name outperforming at down just 18%. pic.twitter.com/jKyOX4rEi9
— Evan Medeiros (@EvanMedeiros) March 16, 2020
As if it couldn’t get any worse, during this same time period we also saw a major disruption in the oil market after a contentious collapse of an alliance between the OPEC oil cartel and Russia, causing a more than twenty percent single-day decline for crude oil and subsequent weakness due to production disagreements.
The outbreak and spread of COVID-19 — combined with the preventative measures of social distancing, stay at home orders issued across countries, and the shock to both supply and demand side of energy markets — wreaked havoc on financial markets and led to one of the sharpest and most aggressive drops from all-time highs that we have ever seen.
There are a lot more record-breaking stats that we could throw in here, but since at the time of writing this it is still an ongoing panic, we’ll save those for a later blog post.
Not all brokers are created equal, there are costs associated with “free”
In 2019, traders got one of the greatest subsidies of all time: online discount brokerages across the board slashed commissions down to $0. Commissions represent one of the biggest drags on profitability for active investors so this was a big win for millions of “at home” traders.
However, after what we have seen throughout this extreme volatility, we learned that all brokers are not equal, and free platforms might not be so free after all.
Take, for instance, Robinhood, the broker that pioneered zero commission trading long before the rest of the industry caught up. They had their service go down more than once during the bear market.
This wasn’t just a temporary outage. This happened on multiple occasions and resulted in traders being unable to place new orders or modify existing positions.
Let’s be real clear, this isn’t during a sleepy period in the markets where there wasn’t a lot going on. This is during one of the most volatile periods in stock market history and investors were unable to access their accounts to make any changes.
And it wasn’t just Robinhood.
I have some retirement accounts with Bank of America Merrill Lynch and they also had multiple periods of down service.
At one point near the end of the trading day, I submitted a market limit order in an actively traded liquid ETF. I sat there waiting and watching as my submitted limit order was resting above the current bid/ask spread but I wasn’t getting filled.
After about 60 seconds, I canceled that order, and repeated with a second limit order, thinking that maybe my first didn’t actually go through. Same behavior, the order just sat there open with no fill.
So I did something I never do. I entered a market order to get me in at any price.
My order was received with no issues — and keep in mind this is an ETF trading thousands of shares in front of my eyes — and my market order to buy just sat there like it didn’t exist.
I kept the order in until the market closed, thinking maybe their front end website just wasn’t updating.
Later that day, I received this email from Merrill acknowledging their issues:
I never got my fill.
These are things you can’t possibly account for when you’re a new trader learning from books and blogs about how markets work. When you’re backtesting a strategy, there’s no warning sign that pops up and says, be careful, your order may not go through on this day. This type of behavior is only learned and fully appreciated through first-hand experience.
The intention here isn’t to single out any individual broker. I think during extreme volatility, all brokers are susceptible to outages and service issues and ultimately it is your responsibility to figure out how to minimize that risk.
The takeaway is two-fold. Be diligent about the broker you choose to invest your hard-earned money with and be sure to keep an open mind and plan for service disruptions during extreme market conditions.
Position size is the ultimate form of risk management
Time and time again this lesson gets pounded into my head as one of the most important concepts for traders to learn. After consecutive weeks of repeated limit down future sessions, circuit breakers triggering during regular trading hours, and extreme illiquidity in small and mid-cap stocks near market opens, it’s extremely important to be mindful of your position sizes.
Simply put, your well-intention stop losses are no good.
If you’re an overnight trader that holds large position sizes with tight stop losses, you are tempting the Market Gods to put you in a very difficult and painful situation when large overnight gaps occur. Combine the overnight gaps with potential circuit breakers firing in the first several minutes of the market open and you’re effectively rendered unable to sell out of your trade at prices anywhere near your desired stop loss levels.
We just recently published an article, Position Size Versus Stop Loss Tug of War, where we show how widening out your stop loss doesn’t have to mean you increase the risk in your trade; in fact, if you control for position size, it means the exact opposite – lower risk.
At the end of the day, controlling position size is the ultimate form of risk management.
Risk happens fast and it always comes as a surprise
Not only does risk happen fast, but it’s often really hard to appreciate and recognize just how vulnerable and dangerous an environment is in the heat of the moment. One reason for this is because the market does a great job at creating an illusion of safety. Take, for example, this chart of the S&P500 in the previous year (2019).
Notice the extent of the pullbacks all year was a whopping -7.63% in May.
The market spent an entire year rallying relentlessly while conditioning investors to BTFD to get rewarded. To be fair, this has been the winning formula for quite some time, but 2019 is a great recent example of even shallow pullbacks getting bid immediately.
Flash forward to 2020 and the script completely changes. The innocent-looking garden variety dip turns out to be an aggressive monster of risk that is about to swallow every investor in its path that doesn’t immediately move out of the way:
This new sequence creates an epic snowball of confusion, panic, fear, and demand for liquidity as the majority of participants are caught flat-footed, unprepared, and racing to the exit doors. The catalyst is the virus, but the mechanics of the market meltdown follows the same script we’ve seen over and over again, albeit a heck of a lot quicker this time around.
One other semi-related point worth mentioning on this topic of risk happening fast is that hindsight is 20/20.
It’s really easy to look back over charts during high periods of volatility and drawdowns and assume that you would have acted with 100% discipline and clarity in the heat of the moment, exiting when your favorite indicator rolled over, or when the market broke your trend-line.
The problem is you have no skin in the game when you’re eyeballing charts or backtesting systems. The events aren’t happening in real-time, the horrible news isn’t flowing 24/7, and your friends and family aren’t calling you worried about everything going on.
It’s only when you actually have live capital on the line and you’re living through the quickly unfolding events where you will really feel the emotional stress and pressure the market is pressing onto you.
That pressure can absolutely make you do silly things.
Your first loss is always your best stop loss
That above chart of the S&P500 meltdown probably already does a good job at illustrating this lesson, however, let’s use our Merlin trading system as a more concrete example. We had a lot of long exposure coming into the month of February and we began getting stopped out of an initial wave of positions on that first leg down into the 2/28/20 lows. Here are six positions we exited on that date:
| Stock | Exit Price |
|---|---|
| CVS | 64.38 |
| FB | 182.55 |
| KL | 39.26 |
| EW | 231.46 |
| MKTX | 361.79 |
| PAGS | 31.25 |
Now let’s assume that we were stubborn and didn’t exit any of those positions on that day because we felt “the market fell too fast” and was due for a bounce. Here’s what those same stocks would have returned just 16 days later on 3/23/20 if we held on:
| Stock | 16 Days Later | Percent Return If Held |
|---|---|---|
| CVS | 53.09 | -7.52% |
| FB | 148.10 | -18.87% |
| KL | 27.40 | -11.61% |
| EW | 157.23 | -23.38% |
| MKTX | 281.31 | -14.10% |
| PAGS | 14.95 | -52.16% |
Every single stock continued to sell off further and nearly all went on to fall double-digit percentages from our exit point.
When markets make extreme moves that haven’t been seen in years, often times a trader’s first instinct is to fade that move or consider it “stretched.” This often can lead to “deer in the headlights” type behavior, or worse, the trader may decide to double down and average into losing positions.
Don’t let that be you.
This lesson is applicable to all markets, but especially in down markets and bear markets. I assure you, your first loss will always be your best loss, so don’t hesitate, rip off that bandaid fast – you will be glad you did.
Lessons Learned Trading a Bear Market Part I: Coronavirus 2020
I hope some of these thoughts and lessons are as helpful to you as they are for me. I write this blog just as much for myself to look back and reflect on as I do for others to learn from.
Documenting what’s happening in real-time, especially during extreme conditions, is a great way to prepare for the future and hopefully not make any of the same mistakes twice. I encourage you to journal and reflect on your own thoughts for this very reason.
Remember, as the saying goes, it’s okay to be wrong, but it’s not okay to stay wrong.
Are you trading right now during these extreme times? Do you have any observations or lessons that you would like to share to possibly help other traders? I’d love to read them in the comments section below.
Thanks for reading and stay safe and healthy out there.
Enjoy what you read? Share it below and be sure to tag @thetraderisk.
Posted in Article, Trading Education, Trading Wisdom
Tagged with Bear Markets, Drawdowns, Entries and Exits, Market Environments, Position Size, Stop Losses
Hello Evan —
So great of you to take the time to analyze what happen. As my sister’s financial advisor told her last week, “You usually don’t get hit by the bus you see coming.” (As you can guess, they didn’t see this one coming.)
I always try to preface my comments with the remark that I don’t know much but for what it’s worth:
In regard to STOP positions, I’ve been badly burned by having 15-20% stop loss settings on ETFs (see attached 2015 letter to the SEC). So in regard to Merlin’s picks I’ve been using STOP/LIMIT orders simply because of the unlikely — but real — risk of flash crashes so deep that the order gets filled far below the set STOP. Of course there are trade-offs but ETFs especially can fall much faster than their underlying security.
So far I’ve been setting the limit on Merlin trades about 10% below the STOP. If you have a perspective on that %-age, I’d appreciate hearing it.
Again thank you for taking the time to make things more comprehensible and for staying the course.
Cheers,
Todd
————— Original Message —————
From: Todd Katz [[email protected]]
Sent: 9/7/2015 1:23 PM
To: [email protected]
Subject: Re: SEC Response HO::~00528221~::HO
Thank you for the response from Mr. Rinell Randolph on Sept. 3, 2015. I’ve done a bit of further research on the behavior of the stock market and ETFs on Monday, Aug. 24 and would very much appreciate the following commentary being added to your searchable database.
On August 24th, 2015 at its low of the day — the first 10-15 minutes of trading — the Dow Jones Industrial Average (DIA) was down 10.5% compared with its Aug. 21 opening. That’s a lot … but not much compared with the behavior of many exchange traded funds (ETFs) composed entirely of the same highly-rated, low-risk, high-dividend paying stocks.
For example SDOG, a fund managed by ALPS, hold only the “Dogs of the DOW” — high-dividend, low-risk stocks — such as General Electric (GE), Consolidated Edison (ED), JP Morgan Chase (JPM), Waste Management (WM), and so forth. SDOG ETF turns over an average of 200,000 shares daily so it has reasonable liquidity. On “black Monday”, the worst performing of the 49 stocks in SDOG’s portfolio was JPM; at its low point it was briefly down 15%. By contrast, some stocks in the SDOG basket were basically unscathed on Aug. 24: WM and Pitney Bowes (PBI), another in SDOG’s securities basket, each fell a maximum of only about 1%.
Here is are the numbers: on August 24 the average maximum drop by the 49 stocks in SDOG’s portfolio from the Aug. 21 high was 4.59%. Contrast this average loss (not accounting for a possible over-weighted/under-weighted portfolio) with the behavior of SDOG itself. At day’s low — i.e. ten minutes in, 9:40-9:45 a.m. EDT — SDOG traded as low as $19.11. That’s 47% below its Aug. 21 opening price of $35.67 (on the 21st SDOG closed at $35.20; off ~2.5% for the day). YES, on Aug. 24 SDOG’s loss was more than order of magnitude (1,022%) worse than the average of its underlying component securities (-47% vs. -4.6%).
Unfortunately for investors, SDOG’s behavior was more the rule than the exception. Widely held and quoted PowerShares QQQ (NASDAQ top 100) was briefly down 20%; VIG, Vanguard’s dividend appreciation fund, was down 38% at its low; Blackrock’s iShares high-dividend ETF called HDV fell 44%; and PowerShares Dividend Achievers ETF (PFM) trading briefly at an amazing 68% discount of $6.58. One notable exception in this blue chip ETF debacle was Schwab’s dividend fund: SCHD was off a maximum of “only” 15%.
Of course things did not end so badly. By the end of trading on Aug. 24, PFM actually closed only 9 cents below its open (open: $19.40; close: $19.49). However, there were some losers: 7,000 shares of PFM traded at or near that $6.58 low. SDOG actually closed higher on the day (open: $32.34; close: $33.75).
Since the panic was a flash crash some may take comfort in the fact that only those with STOP positions were directly affected. Growing unease and uncertainty aside, the problem is that if the STOPs at such breakpoints as -8% or -20% become unreliable and therefore unusable as an investment protection tool, what happens if there is a panic or crash and no immediate bounce back? Are you then the owner of an EFT or securities that have lost half their value in a day? And, in regard to ETFs, how confident can you be that some other event or rule invocation will not — in an even more disastrous, longer-term manner — separate the value of a established, liquid exchange traded funds from the value of its underlying holdings?
Finally, there are apparently many investors who believe that Rule 48 was designed to primarily facilitate or benefit high-frequency trading. It would be helpful if the NYSE clarified the purpose of this rule and specifically addressed its effect in regard to high-frequency trading and the overall stock market.
Sincerely,
Todd Katz
Hey Todd,
Thanks for sharing and oh boy do I remember that week in August 2015 very clearly. I almost included some of the parallels from that time. The term I like to use is dislocation, and just like you wrote in your letter, we saw it during the 2015 period, we saw it recently during this meltdown, mostly in fixed income products, and I’m willing to bet in a future panic/crisis we’ll see it again.
In response to your question on Merlin and stop orders in general, I always use stop limit orders (never stop market orders) to protect against times like these. I personally keep the limit price very tight, so for Merlin specifically, if our stop loss is $50, my sell stop will be $50 with a $49.90 limit price. This will ensure I don’t get completely robbed by market makers during a quick sell off and 98% of the time this works and protects me with no problem. For the 2% of the time a gap occurs or liquidity dries up and I don’t get filled, then I manually intervene, cancel the order, and then exit the trade myself ASAP.
Let me know if this doesn’t make sense. Enjoy the weekend!
Somehow I came across your site on Youtube. I watched and liked what I saw. I am an older timer, first getting into the markets in 1990. I was very fortunate at that time to come across Investors Business Daily and William O’Neill. Following IBD and its methods not only made me some very good money over the years, but it also got me out in late March 2000 with a very nice profit. I bought a house and stayed “mostly” out of the markets for some time, consistently losing smaller amounts. Then for many years I was not in too much as I had a construction business that was successful and kept me away from the computer during the day. The O’neill methods take some attention and I didn’t have it to give. Now I have retired and am back “in the game.” Thank you very much for the informative blog. I will look more at your offerings as you are clearly a Professional. Thank you, Richard Di Lorenzo
Hi Richard, it’s nice to hear from you and good to know the O’Neil methods held up well during the 2001-2002 bear market. Having a plan/system/set of rules is of course the big first step and then the trader actually needs to be able to follow those rules when the rubber meets the road. Sounds like you were able to do both. If we can be of any help to you, services or otherwise, don’t hesitate to reach out.