First, you need to form a hypothesis of what’s going to happen.
Because if you trade without conviction, you won’t be able to stay in trades and let your winners ride.
And to form a hypothesis, we need to examine the current market environment.
We are currently in a market that’s driven by headlines. The main focus is on the U.S. China trade war, global economic slowdown and the possibility of a U.S. recession.
We know President Trump does not want the stock market to fall and he doesn’t want to see the country in a recession. However, he also wants to get a more favorable deal with China.
We also know professional traders are selling this latest S&P 500 rally.
How do I know?
Take a look at the various markets. The bond yields are at their all-time lows and both bonds and gold have been rallying for a few months . That tells me we are in a “risk off” scenario. Traders are looking for a “safe haven”.
However, the markets never make it that easy. And usually what ends up happening is a “maximum pain” scenario – the markets move in the direction that punishes the most traders.
Since most traders are buying bonds and gold and shorting the S&P 500, the “maximum pain” scenario would be for the stock market to break out and make new all-time highs and for bonds and gold to collapse. If that happens, most traders will suffer… a lot.
Could that happen?
Well, we could get positive headlines leading up to the U.S. China trade talks in October and the Fed can cut interest rates by 25 basis points in September.
Most traders would say: the U.S. China trade talks are fake, there will be no deal in October. They would also say that lowering the interest rates by 25 basis points won’t help drive the economy. And therefore, the S&P 500 has to be a good short.
I don’t agree. And I actually think the opposite is likely to happen.
I think we will have a rally in the stock market and gold and bonds will significantly decline.
And that’s my hypothesis.
Next, you have to determine how to actually trade your hypothesis. I use options because they give me the ability to maximize my profits.
But that’s a story for another time…