Active Trader - Short against the Box

Welcome back Active Traders.

It was a bruising week for the bulls, with the markets selling off sharply and taking out the recent lows set in mid-August.  Even so, the markets have come back to levels set in mid May of 2014.

Taking the long view, the SP-500 has come a long way from the low set during the financial crisis.  I ran the numbers and SPY bottomed at 67.10 back in March of 2009 and had its highest closing high at 201.85 back on September 19, 2014.  So the SPY is up nearly 200% from that low.  Given Friday's close at 190, we are off only 5% of that total move which is not that much.

Since the year 2000, we have had 2 major sell-offs which cut the market nearly in half.  I don't expect that type of damage given the perpetually low interest rate environment.  However, we clearly could go a lot further to the downside.  How to cope with it?

1) Don't let any open positions exceed your pre-defined stop-loss value.

2) Take it from day to day, Focus on what's happening today and trade it.

3) Wait for a rip-the-shorts-heads-off rally, then put on an offsetting position.  This past Tuesday was a perfect opportunity where the market ripped to the upside then stalled out right at the top of a declining trend channel.

The quickest and easiest move is to short-against-the box or simply sell short an equal amount of what you are long.  This has the following advantages:

• Your position is effectively flattened - minus commissions of course
• You avoid capital gains taxes on your taxable accounts
• In your IRA you can just sell the shares since you don't have the problem with capital gains tax.

But don't overstay on the short side since on a longer term basis the odds are not in your favor.

At most, you are going to catch only part of the down move and that's okay.

Just hearken back to the Average Change by Week of Year chart from my post Evidence of Autumn.  Looking at this chart, you will see that the market tends to sell off during this period, but on average, closes higher by the end of the year.

So don't get too bearish and abandon all your longs, because history shows your losses will recovered and your account will eventually go on to higher highs.

So tread lightly for the remainder of October, it will be November in a few short weeks. Have a great week ahead.