Stock traders, just like long-term, buy-and-hold investors, must balance their risk through diversification. This includes:
•    trading stocks in different industry sectors
•    trading stocks in companies of various sizes or “market caps”
•    at least considering trading different asset classes, such as commodities or currencies

However, diversifying also includes having open positions split between long (buying) and short (selling) positions. Although it may seem nonsensical to have open short positions during a market rally, or open long ones during a fall, it’s merely good risk management. Note that traders who followed this rule likely earned substantial profits during last week’s sharp market correction.

During a bull market, short positions must be carefully selected. Even then, they’re likely to earn only a small profit, at best. However, should the market suddenly turn south, the resulting larger profits from these short positions will balance the losses from the long positions in the portfolio.

Prices always fall harder and more quickly than they rise, as fear will dominate greed. Therefore during a bear market, long positions hold somewhat less importance than short positions held in a bull market, and stop losses should be kept tight.

Being “net long” in stock market terminology means to have a preponderance of long positions within one’s current trading portfolio. Being “net short” is the opposite, holding mainly short open positions. Whether a stock trader is net long or net short within a given market of course must depend upon the market. The question is, how to judge the market to determine whether one should be net long or net short?

The most common method of determining market condition is with a technical indicator on the preferred market index. Wall Street utilises the Dow Jones Industrial Average or the S&P 500 for domestic trading; London uses the FTSE 100. In Australia, the preferred index is the S&P/ASX 200 (XJO).

Although traders can use whatever technical indicator they prefer, care should be taken to select one that responds with sufficient speed to changes in market conditions so that losses can be managed, without generating large numbers of whipsaws. The most common for this purpose is the nine time period simple moving average, or SMA-9, applied to weekly charts.

When the SMA-9 slopes down on the index chart, traders should consider adjusting their positions to be net short. When the SMA-9 slopes up or maintains a level stance, those are the times to be net long. Remember that in the long term, the stock market trend is always up, which is why a level SMA-9 can be interpreted as positive on the average.

Below is the current chart of XJO over the past three years (showing weekly candlesticks). The SMA-9 is in purple atop the chart:

Note that the SMA-9, despite the early week’s impressive performance, continues to slope down. The market remains cautious and net short.

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