Collapse or big bounce, how to prepare for what’s coming next

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The S&P 500 remains near multi-week lows as it processes the recent selloff.

Higher or lower, that is the question. And right now the S&P 500 is standing on the trapdoor.

The encouraging news is we violated recent lows multiple times over the last few sessions without triggering a larger tidal wave of defensive selling. Dip buyers often leave stop-losses under the lows and any violation triggers waves of reflexive selling. But so far, we slipped under the lows from two weeks ago and these subsequent violations failed to trigger follow-on waves of selling.

This is good for the market because it means most owners are holding steady and are not letting some arbitrary level determine their next trading decision. The bad news is the longer we hold near the lows, the more likely it is we violate them and few things shatter confidence like screens filled with red.

While we have inflation, debt ceiling, and Evergrande headlines swirling around us, that is largely a distraction from what is really driving this volatility, sentiment. Traders ignored headlines all year and there is no reason this latest round of headlines is any more significant. Instead, many traders realize it’s been a nice run and they fear the “inevitable” pullback more than anything in the press. These people are not selling because they fear inflation or Evergrande, they are selling because they want to get out before other people start selling. It is simple as that.

And so the answer to the question of what comes next comes down to how many people are confidently waiting for the bounce versus how many are on the verge of abandoning ship.

While lots of people are speculating over what comes next and it’s been a long time since I heard this many people predict a stock market crash, only time will tell what comes next. If there was a reliable indicator, everyone would use it. And since people promote a million different indicators, we know most of them don’t work. Because if one worked, we wouldn’t need the million other indicators.

Anyway, the simplest way of trading a volatile market is following its lead. If the selling continues Tuesday, we step aside and let it do its thing. If prices bounce Tuesday afternoon, we buy the bounce again. And if we get an inconclusive indication (not a bounce and not a further collapse), we simply push this decision to Wednesday.

And as always, start small, get in early, keep a nearby stop, and only add to a trade that is working. While buying Friday’s bounce didn’t work, if we are sensible about the way we enter a position, the risks are small and the potential rewards of getting it right are large.

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