Why This Sell Off Will Be Steep

• Tweet
• Pin It

Like good little puppies, we’ve been trained to buy the dip all through 2012.  Stocks sell off on bad news?  Buy the dip and you are rewarded the next day with a nice rally.  AAPL sells off?  Buy that sucker fast because in two days it will be at new all time highs.  PCLN or CMG takes a hit?  Just hold on because in a few more days . . . you guessed it . . . new all time highs.  It doesn’t get any easier than this.  And that’s the problem.

Like Pavlov’s dog, the retail public has been trained, and trained well.

Don’t get me wrong; there is absolutely nothing wrong with making money buying the dips.  It’s a great way to make cash and I do it myself.  In fact, when trading options, there is no easier way to make money than buying slightly in the money calls on a steadily rising bull market.  The premiums are lows, the swings are manageable, and the profits are awesome.

The problem is simply this:  Markets change.

Nothing goes straight up or straight down forever.  The key to mastering the markets is to recognize when the internal structure of the market is changing.  Trading professionals recognize this as a shift in order flow.  Up to this point, all through Q1 of 2012, order flow has had an upside bias.  This means the amount of money flowing into the market has consistently exceeded the demand of the money flowing out, thus pushing prices higher.  It is as simple as that.  Professionals know this and they have a simple practice they employee in their daily trading routine: never fight order flow.  And order flow has been pushing stocks up, up, and up.

However, once that bias ends, buying the dip can be catastrophic to your account.  It is during these “shifts in bias” that the retail public typically loses all that they have made . . . and more.

Why?  It’s really quite simple.  Once the retail public has been trained to buy the dip, institutions can then prepare themselves to unload their holdings on an unsuspecting public.  It’s called “creating a market demand for your product.”

It works like this.  Joe Trader has been making money buying AAPL on dips for the last three months.  He’s excited.  He starts mapping out a strategy over the next several years, and he visualizes himself making hundreds of thousands of dollars using this strategy – maybe even millions!  He starts planning on when he is going to quit his job (if he hasn’t already) and what he is going to do with his new wealth.  He even tells all his friends.

And here’s the rub.  He won’t change his strategy.  He has made a decision, and he will stick to that decision.  Human beings have this nasty tendency to defend the choices they make.  If they make a good choice, then defending this decision reaps rewards.  If they make a bad choice, then defending this decision leads to ruin, heartache, frustration . . . the list goes on and on.

The professionals know this, and they use it to their advantage.

They’ve had a nice run and they’ve got some nice profits and it’s time to cash them in.  What they do is start selling – and the retail public buys these shares.  Then the pros ease off their selling so as not to scare the public.  The markets rally.  The public is happy.

And then, WHAM!

The pros sell some more.  The public buys these shares.  And the pros ease off, letting the market bounce a bit.

And then, another WHAM . . . you get the idea.

What happens here is that the public keeps buying the dip, and they end up digging themselves into a big hole.  And guess what?  Instead of cutting their losses . . . they instead DEFEND THEIR CHOICE and keep buying AAPL (or whatever stock it is they like) as it goes lower, lower and ever lower.

They typically will only sell when one of two things happen.  First, they can’t take the pain anymore.  Out of pure anger and frustration they dump their shares and then drown their sorrows in their beverage of choice.  Or second, they get a margin call from their broker, which leaves them no choice but to blow out their account.

It’s ugly.

And it’s planned.

Be aware of the plan.  This market is showing every sign of wanting to have a serious roll over.  Last week I talked about buying SPY puts.  Keep them.  I’m looking for the S&P 500 to get to 1330 at a minimum, and from there we will probably test 1300.  It won’t be straight down.  Remember, the pros have to give the retail public some strands of hope.

And if you are buying dips – just keep your stop losses in place.  Don’t get sucked into defending your position all the way to your portfolio’s grave.

Successful investing,

John Frederick Carter

facebook   twitter   linkedin   reddit   email