Sunday, August 7, 2011

Catching the falling knife

With the S&P's downgrade of US debt a reality, the question now is finding and trading the bottom on the market.

The S&P 500, as well as nearly every other stock index, was devastated last week. Fortunes were made and lost, and the careers of many amateur traders likely came to an abrupt end. It still remains to be seen, however, exactly how much more downside is left.

It's very likely that a large part of the selling we saw last week was insider trading based on advanced knowledge that the downgrade would occur. This could mean that the majority of downside is already priced into the market. It's also possible that this is just the beginning and we have a long way to fall yet.

Personally, I believe the most severe selling has already happened. I think it's likely that Monday sees an additional reflex selling flush that possibly even lasts into Tuesday. From there, I think it's possible a short term bottom on the market is in.

Alternatively, fear and panic, as well as hedge funds liquidating their holdings, could drive the markets substantially lower. I think this is the least likely scenario as it assumes that large financial institutions have not yet begun to sell.

In any case, I will be trading carefully. I mentioned several times last week that I would not be holding any large positions into this kind of uncertainty and that continues to be the case. I will be looking mostly at short term scalp trades and closely watching for signs of a low in the market. Once the market bottoms, we should see a substantial relief rally.

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