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It would be nice if we could find a trading strategy that worked in all markets, whether the market was in a boom or a recession. It sounds like a fantasy, but we can build steps into our everyday trading that can protect us against recessions or catastrophic market meltdowns.
Facts About Recessions
· Recessions occur about every 4-6 years
· Recessions cause the stock market to yield 35-45% of its value
· All recessions have led to the stock market eventually regaining the value it had prior to the recession and reaching beyond it to make new highs
From these facts, we can infer some things. Recessions are inevitable and we should keep this in mind when using or building our trading strategies. If we know a recession will give up 35-45% of its value, we can set some percentage that we feel signals a recession. You could use 10% for example. Then we could utilize an inverse ETF to take advantage of the remaining drop.
What is an Inverse ETF?
Inverse ETFs are exchange-traded funds (ETFs) are designed to profit from the decline in its underlying assets. These are sometimes called short ETFs because you are essentially shorting the market when you buy them. But it eliminates the need to actually borrow the stocks that you sell short.
Here is how you can use trailing stop losses and inverse ETFs to build a recession-proof trading strategy.
1. Set a percentage loss for each asset you own that you feel signals a recession. You could use 10% for example.
2. Set a trailing stop on all your assets so your position is closed when its value drops 10%.
3. When this happens and you have confirmed that a recession is underway, you can enter an inverse ETF to ride the market down the rest of the way. Since the average drop in the stock market is 35-45% of its value in a recession, you could gain as much as 25-35%. This allows you to potentially gain back the 10% you lost and gain some.
4. Establish a point in the market where you want to re-enter. At that point, you would exit the inverse ETF and re-enter the stock market long. You can play this two different ways. You can:
- Put in a limit buy order to enter at the point where we get in before the market recovers.
- Wait for the market to recover and confirm that a stable uptrend out of the bottom is underway.
- Choice A means that you will very likely get into the market before the recovery begins. But if the market recovers before then, you might miss it. Since our statistics say 35-45% of the market's value will be lost, it is probably a safe assumption that the market won't recover much until it reaches that point. You could set your buy limit at around 27% or 30%.
- Choice B means that you would miss a lot of the value gain coming straight out of the recovery. However, if you went with Choice A and entered well before the recovery began, you would already be behind by that difference. So, the distinction between these two strategies for re-entering the market ends up being a matter of personal taste.
