Over the Halloween weekend, my family and I ventured up to Walt Disney World for Mickey’s Not-So-Scary Halloween Party. The kids had a blast, but their favorite part wasn’t the Halloween parade or trick-or-treating.
Instead, it was being able to ride rides with hardly any wait times.
My 6-year-old son’s favorite one is Space Mountain — a roller coaster that climbs into “space” and then whips around through a pitch-black dome. Thanks to the low wait times, he got to ride it four times in a row. If you’ve ever been to Disney, you know that’s a lot.
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But even after our fourth time, I still wasn’t used to the jerks and drops the ride had in it. Because it was so dark, I couldn’t predict anything up ahead.
Right now, the stock market is on a roller-coaster ride, but thankfully it’s not as difficult to anticipate the whipsaws ahead as Space Mountain was.
In the month of August, stocks experienced the largest amount of volatility in the past four years.
Then, in October, stocks experienced their strongest month of returns in the past four years, and they have continued higher at the beginning of November.
Even though stocks are showing strong momentum to the upside, I’m using this rally as an opportunity to lock in gains.
Honestly, I think the stock market is nearing the top of this roller-coaster ride and is set to plunge sharply soon.
Here’s why and what you can do about it.
Stock Market Roadblock
A key element in any stock analysis I do is to determine the general trend of the stock. In short, I am looking to see if it is making higher highs and higher lows or lower highs and lower lows.
The concept is simple to understand.
If a stock is setting higher lows on each pullback, it means there are more buyers than sellers. In turn, if the stock is setting lower lows on each pullback, it tells us that there are more sellers than buyers.
Right now, even with the recent rally, most stocks are making lower lows and lower highs — this is true for broad stock market indices such as the Dow Jones Industrial Average and the S&P 500.
To understand what I am talking about, take a look at a chart of the Dow Jones:
As you can see, the red dot represents the lows (15,370) for the past year, which occurred in August. The black line represents the level (18,350) that would set a new high, which is the key level to watch going forward. From the Dow’s current level, it has room to run less than 3% higher before potentially hitting a wall.
If broad markets fail to set higher highs above that level, look for a quick pullback to test the red dot level, and likely fall below it, which is what I expect to unfold in the coming months. Just dropping to the August low represents a decline of nearly 14% from current levels.
But, by knowing the critical levels of the stock market, you can prepare yourself to exploit large gains.
Prepare for the Drop
Most investors believe the only way to profit from stocks is to go long, where a stock has to rise for you to generate a profit. But it can be even more rewarding to go short, where you profit as a stock falls in price. It’s just difficult to time that quick move.
However, the market is not a pitch-black ride at Disney World. We can make educated guesses of what lies ahead based on what indicators are telling us. And right now may be an ideal time to add to the short side of the stock market.
Don’t get me wrong, most of the time stock markets are in a bull market. But the short, steep drops that happen in bear markets are enough to wipe out a portfolio in quick fashion, if you’re not prepared.
The easiest way to protect gains and profit as broad markets fall is to buy a put option on the S&P 500. You can use the SPDR S&P 500 ETF (ARCA: SPY) to do so.
But if you’re not the type to buy a put on the S&P 500 or use a put option to protect your long positions, I would use the recent rally as an opportunity to take gains off the table; it’s exactly what I recommended my readers do last week.
Just think of the market as if it were a roller coaster. We are approaching the top after a long, steady climb to the top. Are you prepared for what lies ahead?
Editor, Pure Income
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