Portfolio Management | August 24, 2020

Trading in the Wake of a Downturn

There’s market volatility—and then there’s what happened in the first half of 2020, when COVID-19 sent the S&P 500® Index into its fastest 30% decline ever, only to recover the majority of those losses in a matter of weeks.

So, what lessons can traders learn from this recent market turmoil? In a wide-ranging Q&A, three Schwab Trading Services professionals—Lee Bohl, Kevin Horner, and Joe Mazzola—discuss their key takeaways from the turbulence and provide tips for moving forward.

Is the recent episode of extreme volatility unprecedented?

Joe: “We’ve certainly seen bouts of heightened turbulence before, but nothing like this. If you were trading on traditional fundamentals, those were all but meaningless once the crash began. In fact, it forced fundamental traders to turn to nonfinancial data for information, focusing on things like science, sentiment, and the stimulus.”

What’s the big lesson traders should take away from this episode?

Kevin: “We went 11 years without any real tests or market shocks, which may have lulled some traders into a false sense of security. This is a chance to remind ourselves of complacency risk. It’s the nature of the game: You’re going to go through periods when you’re absolutely crushing it—but there’s always the chance you’re the one who’s going to get crushed.”

Joe: “You also need to determine what percentage of your portfolio you’re really comfortable trading. I’ve always looked at it this way: I don’t want to enter a trade unless I’m willing to lose that money. That doesn’t mean I’d be happy about losing it, but if I can handle the loss both financially and mentally, it helps keep me focused on the trade itself, rather than fear or greed.”

Did anyone succeed during the recent downturn?

Lee: “There were several periods during which the market was up a few hundred points for a couple days, then down several hundred points, then up again. So, to a certain extent, the traders who found the most success were those comfortable trading momentum—that is, trading the short-term trend to capture gains quickly.”

What can traders do to manage risk moving forward

Joe: “It doesn’t matter whether you’re trading stocks, futures, options, whatever—just go smaller. Correct position size becomes that much more important when the swings are bigger. I also believe in ‘going home flat’ when the market is choppy—that is, not having a position open overnight, because that’s when things can go sideways for you. Take as much of that risk off the table at the end of the day as you can.”

Lee: “If your old trading style was simply to watch your positions and see how they behaved before acting, then you need to have a better exit strategy. Automatic orders can be a huge help when market velocity picks up, because you’re unlikely to act fast enough on your own. You also may need to manage your limit orders—where you set a specific price at which you want to buy or sell a position—differently. In particular, when the market is experiencing big swings, your position is more likely to reach its limit price, so setting your limits further away than you might otherwise can help avoid triggering a sale prematurely.”

How do you regain confidence after something like this?

Joe: “No matter how strong a stomach you have, when you see your investments drop 30% in a matter of weeks, it’s tough to deal with. Nobody is that cold-blooded. Part of the challenge is determining your degree of fortitude ahead of time. Whether you’re a trader or a long-term investor, it’s all about knowing how much risk you’re truly comfortable with.” 

Kevin: “A trading plan is always important, but it’s even more so during a down period like we’ve had this year. In addition to rightsizing your trades and establishing your exit points, you have to look objectively at your winners and losers. Dig into your results and find out where your profits and losses are coming from. If the profits aren’t there, that should encourage you to step back and reassess your plan.”

Does it ever make sense to just sit it out?

Lee: “Absolutely. For traders, it’s never a bad idea to just stay in cash until the market settles down a bit.”

Kevin: “Cash is, in fact, a position. And it means you’re prepared to act when you do find an interesting opportunity in line with your risk tolerance. Under no circumstances do you need to be trading all the time.”