Both longs and shorts have a place in the market these days, as indices are trendless and new buys break down quickly, says trader Joshua Hayes. In part one of a two-part interview, he advises traders to enter small positions rather than taking bigger risks than they might in an upward trending market.

Kate Stalter: I am on the phone today with Joshua Hayes of Big Wave Trading. Josh, your model these days on the market is neutral, so why don’t you tell us a little bit about that and about some of the short candidates, or inverse ETFs, or whatever else you’re looking at these days?

Joshua Hayes: Actually, right now I have to look at all sides of the market, long and short, because you just never know which way the market’s going to go.

Right now, our model has been in neutral, and has been since our September sell signal was switched. That was October 4, when we had that large up day on big volume.

Since then, we’ve now had basically three big up days on big volume, but it’s always coming after an extended V-shaped move, so that’s failing to trigger any buy signal.

At the same time, whenever we move lower—anytime from October to December—volume is almost never above the 50-day volume average on the Nasdaq, so it’s keeping this market in an overall neutral, which I guess can be really good right now. Because as you can see after Friday being down 1.26% and after breaking below the 50-day moving average on the 13th, here we are up 3% today with Apple (AAPL) above its 50-day moving average.

The inverse ETFs that I was playing? It would be great once we get a full sell signal…but right now, 3X inverse ETFs, I believe, are just way too dangerous to play in this market. We must see volatility come down and more volume on a convincing move.

Today was very unique in that we had some fresh Europe sell signals Friday. They’re completely reversed today, and some stocks that we recently went long, like Primoris Services (PRIM), Silicon Motion Technology (SIMO), and HealthStream (HSTM), which we then had to cut our losses on, are re-breaking out today on very strong volume. So this is a very volatile market, and caution has to definitely be, without a doubt, priority No. 1.

Kate Stalter: You’ve spoken quite a bit recently, through Big Wave Trading, about how challenging 2011 has been. You’re really underscoring that in your comments today.

How should investors approach either the long or the short side? Talk about both of them right now, and what kind of signals people should be looking for.

Joshua Hayes: Well, we always want to see big up days on big volume, and we want to see leading stocks. By definition of leading stocks, I mean stocks with top-quality fundamentals and technicals near old highs break out on big volume.

On the opposite end, for a good sell signal, you want to see stocks like Apple, Baidu (BIDU), Google (GOOG), Priceline (PCLN), and of our past big leaders break down on big volume.

Right now, when we do see that happen, we get reversals either way, and so many reversals, which is nothing I’m used to personally. Like even in 2001 and 2002’s downtrend, the short signals that I received worked way more than they didn’t work. This year, almost nothing is working, so this means as you go along and as you start to perform worse and worse, it’s best to make trades smaller and smaller.

I know they say you can never get rich putting 1% of your portfolio in a stock. Well, in an ideal situation, you would love to put 20% of your portfolio in five stocks, being long five of the best stocks in the bull market and make a lot of money.

However, in a market like this, that’s suicidal. There’s too many wild, random implosions on a daily basis, up and down in stocks, that I believe you just have to go smaller and smaller and smaller.

Continued…

|pagebreak|

Normally, I would let my cut-losses sometimes ride all the way out until, if I got a signal—let’s say, on HSTM today, let’s say that I get a buy signal—but my normal cut-loss would be a close below the low-of-day today. However, in this market, if it doesn’t move immediately, you’ve got to get rid of it immediately.

Unless you can be around the market all the time, I’m not sure how to tell an average investor to invest in this tape, because this is definitely a tape you have to trade. And since things aren’t working, the one thing you can’t do is not take a signal, because that’s when the signal really works.

So my best advice is to continue to play smaller and smaller and smaller, if you keep losing and losing, and if you’re only putting 1% of your portfolio in each stock, that’s OK. Once you get then a winning streak starting to show up, then you can increase it 2%, 5%, 10%, then all the way up to 20% once the trend actually works.

But we’re in a very trendless environment. Every time the market appears it wants to go one way or the other, it always reverses. This does not happen often.

You cannot find any period, at least since I began in the past 16 years, where this has happened. You have periods in the 70s where it happened, you had periods in the 30s where it happened, but I don’t even believe it was quite to this extent. So you’ve got to play small, and you’ve got to cut losses immediately, no questions asked.

Kate Stalter: So are you using some of these historical models from the 30s or the 70s too, as a gauge for what might happen next in the market, Josh?

Joshua Hayes: Yeah, well, I always compare history, but history never repeats itself. It always rhymes. So I never take what happened—OK, this is what happened in 1933, so this is definitely what’s going to happen in 2011. But since we’re about 85%, 90% correlated, I still believe anything can happen, and I have to use individual charts.

I’ve got to be honest: on Friday, after our Europe short signals, I was pretty confident that this market definitely wants to go down. In my head—I would never trade off that thought. But then today, I look at my scans and I look at some of those recent longs that we took that we were cut out, are clearly giving us another buy signal.

Now, the easy thing to do is to be like, “This market is too difficult, I’m not taking this signal, this signal’s not going to work, none of them have.” However, when you do that, that ends up being the signal that works and produces your 25%, 50%, hopefully a lot bigger gains if you’re using the margins. So it’s just really, really tricky, and I just don’t believe we’re really seeing anything like we’ve seen before.

Periods have looked pretty bad before in the past with Europe, United States, the macro environment, but it seems really dire today and the contrarian in me wants to buy stocks thinking they’re going to hyperinflate their way out.

But overall, ever since LTCM in 1998, nothing’s been the same. The government intervention in the free markets is not good, and now you have this kind of volatility and it’s a byproduct of it.