Never let a trade turn into an investment.
Trading has many truisms that are based on behavioral biases and shortcomings. One of the common ones for both traders and investors is the tendency to enter a position then hold onto it as it drops in value instead of sticking with a predefined stop loss or exit plan. A trader will do some mental accounting that moves the position from the trade bucket into the investment bucket. Amateurs aren’t the only ones guilty of this: hedge funds have special rules built into their agreements that allow the hedge fund manager to put an investment into a “side pocket” that restricts investor liquidity. Professionals and amateurs alike will hold onto the trade until it comes back to breakeven. Unfortunately those trades too often turn into dead money.
The easiest way to avoid letting a trade turn into an investment is to use a trading system that can still profit when prices temporarily decline. The best part about core trading is the emotional component: everyone is happy when prices go up but with core trading you won’t mind nearly as much when prices go down because core trading has a well-defined process to buy more.
I’m going to assume a $10,000 position size for each ETF you target just to make the math simple.
The rules are simple:
- Find an ETF that is diversified, hopefully not in a valuation bubble, pays a dividend, and won’t go to zero.
- Wait for a short-term pullback. Doesn’t matter how you define it – use RSI, Bollinger Bands, Stochastics, whatever. It’s only a guide.
- Buy $3,500 worth of the ETF. If it goes up 3 percent from entry, sell it for a $105 profit.
- If price drops 5 percent from the entry price, buy another $2,000. If price goes up 5 percent from here, sell this $2,000 tranche for a $100 profit.
- If price drops 10 percent from the original entry price, buy another $2,000. If price goes up 5 percent from here, sell this $2,000 tranche for a $100 profit.
- If price drops 20 percent from the original entry price, buy another $1,000. If price goes up 10 percent from here, sell this $1,000 tranche for a $100 profit.
- If price drops 30 percent from the original entry price, buy another $1,000. If price goes up 10 percent from here, sell this $1,000 tranche for a $100 profit.
- If price drops 50 percent from the original entry price, buy another $500. If price goes up 20 percent from here, sell this $500 for a $100 profit.
- If price drops below 50 percent then just sit tight. We’re probably in a recession or you bought a single-country emerging markets ETF. Hopefully the dividend stays relatively intact and you can sit back and collect it.
- Repeat all of the above steps as prices bounce around between the various levels.
- Once price increases 3 percent from the initial entry then start looking for the next ETF that has experienced a pullback.
Do you see the common theme with this core trading strategy? You’re trying to net $100 on every trade. You’re not trying to hit a home run and double your money. You’re just trying to grind out some profits as prices do what they always do: go up and down.
The other neat component to this particular flavor of core trading is that it puts the most money to work in the 0 to 10 percent pullback range. The vast majority of time ETFs will bounce off their peaks and fall back 0 to 10 percent. Every now and then they’ll drop more than 10 percent. The frequency of drops below 10 percent becomes increasingly uncommon and it is extremely rare for stocks to tank more than 50 percent (it’s only happened 3 times for the S&P 500 in the past 100 years). So the idea is that most of your money will have been put to work in the price ranges that are the most likely for stocks to experience. However, dry powder is still available if prices keep going down so you can keep grinding out those $100 profits even if prices are 50 percent below where you first bought in.
Core Trading: the Agony & Ecstasy
As long as you’ve picked an ETF that is diversified, pays a dividend, and doesn’t go to zero, the worst-case scenario is that a global recession hits and prices tank 50+ percent. At the 50 percent mark you’re sitting on a 42 percent loss and the position is only worth $5,753. However, you’re probably collecting a handsome dividend at this point since dividends typically don’t fall as aggressively as prices. And as long as there is an attractive dividend then there will be a price floor for the position.
Core trading will outperform buy & holders in a falling market because you load up on the way down instead of being 100 percent invested at the beginning but will likely lose to a trend trader if the drop is more than 50 percent. It will lose to a buy & holder and a trend trader in a strong bull market as you’ll only be partially invested. But in a choppy market it will eviscerate the trend trader and handily beat out the buy & holder.
But the best part of core trading is that it changes your mind set: you’ll no longer wake up, check the futures market, and feel your heart sink when you see the red numbers. You’ll think “it only needs to drop another X percent before I buy my next tranche.” You won’t get rich fast, but it’s pretty amazing what you’ll end up with once you learn to consistently grind out profits in the market.