In stock market corrections like the current one, rules for when to sell stocks take center stage. Highlighting the troubles, the market indexes — as well as bellwether names like Nvidia, Alphabet Apple and others — have sunk below key moving averages.
But while risk management is vital in this environment, having rules for how to buy stocks when the market recovers is equally critical. Market conditions can change quickly. So it's vital that investors stay engaged, building a list of stocks to watch as they wait for a follow-through day to signal a change in market direction.
Four Things To Know About Stock Market Corrections
As a quick cheat sheet for handling stock market corrections, keep these four time-tested guidelines in mind.
Intertwined with The IBD Methodology, these tenets are based on more than 100 years of stock market history. Using in-depth analysis of stocks from all eras and types of market environment, these guidelines have held true on all the top growth stocks of their time, from IBM in the 1920s and Apple in 2004 to Nvidia today.
1. Most Stocks Decline In Extended Downturns
History shows that most stocks — as much as three out of four — simply follow the overall market trend, either down or up. During an extended downturn or bear market, the top growth stocks that led the prior uptrend can pull back 50% or more.
While leaders like Nvidia, Apple and Google stock have not reached such depths, each has flashed sell signals. While investors still sitting on massive gains in such stocks may choose to hold, managing risk by trimming exposure remains wise. And for investors who bought more recently and do not have a large profit cushion to weather the current storm, a hold-and-hope strategy can quickly lead to large, potentially unrecoverable losses.
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2. Big Profits Come From Keeping Losses Small
A key tenet for savvy investors is to keep all losses small. Here's a simple rule: Sell all stocks that drop more than 7% to 8% below what you paid for them. For example, if you bought a stock at $100 per share and it drops to $92, sell. Such weakness means something is wrong with the market, the stock or both.
Whatever the case, such a decline calls for defensive action to proactively protect your portfolio. You can always buy the stock back if the market improves and the stock sets up a new buy point.
Note that if you sell a stock at a 7% loss, you only need to gain about 8% to get back to even. But if you take a 50% loss, it takes a 100% gain just to get back to square one.
3. Stock Charts Provide Most Reliable Indicators
In times of market volatility and severe downturns, emotions and predictions can take over. Whether it's scary headlines or hopeful hype, news and personal opinions can impede sound decision-making.
To avoid that and stay grounded, use stock charts. They provide the most timely and reliable look into strength or weakness in individual stocks and the market indexes.
Whether deciding when to buy or when to sell, learning how to read stock charts is essential. It's an indispensable skill that will help you pinpoint the right time to buy for maximum gains and when to sell to protect your profits.
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4. All Major Market Rebounds Start With This Signal
In an environment like the current one, the same question continually comes up: When is it time to buy stocks again?
One key signal to look for is a follow-through day.
Simply put, a follow-through signals a change in trend for the better following a downturn in the market. Coming after the market indexes have started to rally, a follow-through day signals a change in trend when the Nasdaq, S&P 500 or Dow "follows through" on that rally attempt with a significant gain in volume heavier than the day before.
Click here for a detailed explanation of what constitutes a follow-through day.
Note that not all follow-through days lead to a sustained new climb. Some will fail, which is why investors should get back into stocks gradually following this signal. But note that no major uptrends begin without a follow-through day.
So waiting for this signal, along with budding rebounds in stocks finishing or breaking out from sound bases, gives investors the upper hand in spotting and profiting from new uptrends.
