How to Profit from a Stock Market Correction
As a stock market trader, one of the worst things that can happen to you is when there is a stock market correction. For the record, a stock market correction is one as stock market index, such as the S&P 500, goes below 10% or more from its high. Moreover, stock market corrections usually last for anywhere from two to four months. Yes, stock market corrections can turn into a bear market.
Now, what we really want to talk about today is how you can profit from a stock market correction. There are various practical trading techniques you can utilize to still make money even in the event of a stock market correction.
These techniques will allow you to reduce potential losses, and even to make money from a stock market correction. Let’s go over all of the different methods at your disposal too manage your risk and to profit from a stock market correction.
Use a Portfolio Defense Mechanism
Generally speaking, in order to manage risk properly, most would recommend that you never invest more than 10% of your portfolio balance into a single stock. This means that if you have a $2500 portfolio, you shouldn’t invest more than $250 into certain stocks. You also want to make sure that you have a stop loss order that is just 10% under your entry price.
The reason why you want to do this, have 10% allocation and a negative 10% stop loss, is because if you lose a trade, you only really lose 1%. However, when there is a stock market correction, this can still be quite dangerous.
The official recommendation here, to get through these stock market corrections, is that you only allocate 5% of your trading capital per trade. This also means that you can have more trades open at once. If you allocate 10% of your trading capital into a single trade, it means that you can have 10 trades open at once.
However if you allocate 5% of your trading capital into a single trade, it means that you can have 20 trades open at once. If you keep the stop loss level at negative 10% from the entry price, this means that you’re only risking 0.5% per trade.
Therefore, you want to allocate no more than 5% of your portfolio portrayed, you want to have a negative 10% stop loss from the entry price, with a risk of just 0.5% per trade, and 20 trades open at once. Another part of this defense mechanism is to diversify your portfolio. Simply put, having all your eggs in the same basket is never a good idea.
Follow the Market Leaders
Yes, making sure that all of your eggs are in the same basket is important. However, how do you know which of the eggs you need to invest in. Yes, there are plenty of opinions out there, but they’re not all correct. Fact of the matter is that you are the one making the final call here, so you’re really the only one to blame. Yes, you have to find the right kind of stocks to invest in. The best way to do this is to use a simple stock Screener.
There is one good theory to take note of here, which is that when a price seems too high and risky to the majority of people, then it will usually go higher. However if the majority of people think that up price is too low and cheap, it will usually go lower. When using a stock market Screener, you want to take a look at the 52 week highs, as well as the rate of change.
Using these two features on any good stock Screener, you can then identify the best stocks to invest in. However, before you enter into a trade, just make sure that the stocks in question still need your general trading plan. No matter the case, you generally don’t want to stray very far from your proven and time tested trading strategy.
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Managing Trades to Decrease Risk and Increase Rewards
Of course, during a market correction, you want to decrease your risk as much as possible while also increasing the rewards. Having the highest possible reward to risk ratio is of course what you are looking for.
There are three things that you can do to assist with this. You can allocate small, you can scale in and move your stop loss to the break even point, and you can also use a trailing stop loss. Let’s take a quick look at all three.
First of all, as mentioned above, you do only want to allocate 5% into a single trade. However, remember that you are in a stock market correction, So what you can do here is allocate another 5% of your stock position. However, you then need to move your stop loss to the break even point.
The last thing that you then need to do is to trail your stop loss. This means that you can keep making more and more money while keeping your risk level in check. using a moving average trailing stop loss can be very beneficial in this sense.
Increase Gains When the Market Correction Ends
Keep in mind that stock market correction is usually end after three or four months. However, a stock market correction can last longer and it may get worse. There’s no fixed rule as to when they will end, so you are looking for a solution, here you want to look at the price.
Here you are looking for the stock index to break and then close above its all time high. If this happens, then there is a good chance that the stock market correction is over. Once this happens, you can then start allocating more money into your investments.
Surviving a Stock Market Correction – Final Thoughts
There you have it folks, you should now be able to survive a stock market correction with ease. Remember, risk management is at the forefront of this stock market correction survival technique.
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