But what if the sell off continues? The same people (which is everybody) who like to say “buy when people are fearful” are also the same people who say “don’t catch a falling knife”!

Confusion! What to do?

The first thing to realize is that in such situations it is almost always wiser to wait and see how price action plays itself out over the next few days. Bear in mind that a lot of the buying that occurs after a massive selloff tends to be short covering as short sellers take profits. 

If the rally fizzles out and price starts to move down again, watch out for selling to get increasingly frenetic.

This more often than not culminates in one or two very long bars on the chart as everyone in the market rushes to sell out of their positions at the same time; mass liquidation in a word – FEAR.

If the rally continues and is confirmed with the market closing higher on consecutive days, especially if it tests the prior lows and rallies off them, it is time to pay attention.

Trying to trade this is still very tricky as short covering, especially at bottoms, tends to feel frenetic, leading to rallies that can be quite substantial, but fade quickly after a few days or weeks.

The rule of thumb here for those who insist on taking risk in these environments is that the quicker and larger the rally, the more likely it is that the move higher is a bear market rally.

Basically, the more the rally resembles a straight line up on a chart, the more likely it is to be a bear market rally, in which case the best thing to do is to identify the longer term trend. If it’s in an uptrend, a long could be a good idea, if it’s in a downtrend, waiting for prices to test a trendline would be a prudent move.

This rule of thumb works because straight line price moves are the opposite of mass liquidation; instead of people rushing to the exits, people are rushing through the entrance. This is a frequent occurrence in two scenarios: bear markets, and the end of massive bull markets.

In the case of bear markets, these straight line bear market rallies occur because people have either yet to fully recognize the severity of selling pressure, or jumped into a short covering rally with premature hope that the selling is over.

The quick move higher from the initial burst of short covering draws more and more people with “false hope” into participating in the rally, all thinking that the bear market is over and rushing to not miss out on the upside.

The same thing happens at the end of bull markets, as price deviates sharply from established uptrend lines, eventually displaying the same straight line behavior described above. More and more people get drawn in as they see everyone around them getting rich and think to themselves “I want in too”.

In an acronym, FOMO.