The Trader's U E-Letter: Issue # 170
Thursday, January 12, 2006
Stock Market Price Shocks: How to Protect Your Portfolio from the Stock Market's Dirty Little Secret
By D.R. Barton, Jr., Chairman, Trader's U
A mere six months out of college, and John, a friend of our family, was already making all the right financial moves…
He had a plan to control his spending and a goal to save some cash so that he could start investing actively within 18 months. He budgeted for a minor indulgence here and there, and his plan was solid based on his prior spending record.
Everything was moving along exactly according to plan - the savings account was growing bit-by-bit, and John was very pleased.
And then it happened - the financial bomb dropped. The transmission on John's car imploded. The car was only a few years old, but was no longer under warranty. The $1,800 was going to smash his budget, eat up all his savings and require him to take out a small loan.
Ouch! Unexpected events can disrupt or even destroy even our best-laid plans.
Like John's unforeseen transmission problem, the market has a particularly keen knack for hitting us with unexpected price moves. And stock market price shocks - unpredictable moves that are too fast to trade - are one of the least understood parts of trading.
Today, we'll look at why price shocks are so important. And we'll see the single most important thing you can do to protect your account from the unexpected.
The Biggest Account Killer: Price Shocks
Price shocks are the stock market's equivalent of a low blow - and the market is a real cheap shot artist. They are the single biggest reason that accounts fail.
And no one is immune. The most infamous hedge fund of all time, Long Term Capital Management, was done in by a series of price shocks (along with poor risk management). One of my favorite books on trading and investing is called When Genius Failed, and it was written about the collapse of this seemingly unstoppable fund. (For more on this book see today's Trader's U Tips & Tricks section below.)
Price shocks show up in several forms. The most prevalent is the overnight gap.
All traders and investors are familiar with overnight gaps. Take a look at the chart of heavily traded biotech stock Human Genome Sciences (NASDAQ: HGSI) that is shown below. After the market closed on October 4, the company announced disappointing clinical trial results for one of its products. The next morning, the stock opened down almost 30%!
People who were loaded up on HGSI got slammed on this fateful day.
Why Understanding Price Shocks is So Important (and the Stock Market's Dirty Little Secret)
Price shocks are important to understand for many reasons:
- They can make a huge dent in your account equity (or destroy it completely).
- Their unpredictable nature means that almost everyone overlooks them or discounts their ability to strike your account or your system.
- We tend to minimize price shocks as "one-time" occurrences that can't happen again.
- Price shocks are easy to overlook in back-testing or system evaluation. (Most back-tested systems perform well because they avoided price shock events - by accident or design.)
- They make your risk much greater than it appears.
This last item is really important… because here's the stock market's dirty little secret:
Price shocks occur much more often than we imagine. And it is difficult and/or impossible to plan for them.
But all is not lost! Price shocks are just another of the stock market's characteristics that we have to deal with as traders and investors. And we have tools that we can use to mitigate price shocks and even take optimum advantage of them when they occur in our favor.
Here are two keys to surviving price shock events in the stock market:
1. First and foremost, plan on price shocks happening to you! There's an old trader's axiom that every market participant has a disastrous trade out there with our name on it. Our job is to minimize the effect of unexpected price shocks. That's why organizations like Trader's U, Investment U and The Oxford club recommend that traders and investors put no more than 1 to 2% of their account equity at risk on any single trade or investment. If you follow this type of prudent risk-management strategy, you will be prepared for almost any worst-case price shock scenario.
2. Learn to identify the reasons for price shocks and how you should react once they happen. There are several reasons that price shocks happen. Next week, we'll take a detailed look at those reasons and how to evaluate them when they happen to you. We'll also look at what your best course of action would be for each scenario. Until then…
Today's TU Tips & Tricks
- I mentioned the great book When Genius Failed by John Lowenstein. This tells the whole tale of Long Term Capital Management from the years before it was formed right up until it brought the world financial markets to the brink of disaster. It's a great read and written so that folks without any financial background can understand all of the concepts.
- Also, take a look back at Trader's U #124, Would a $100,000,000 Loss Help You To Remember Proper Position Sizing? This is a great example of why everyone should pay full attention to the size of their trades…
The Chart of the Week
This chart should look familiar! It was used as our example of an overnight gap in today's Trader's U…
Human Genome Sciences (NASDAQ: HGSI) has hit two important points at the same time: a key resistance level and gap resistance, both from last October. If HGSI can close above $10.30, it should proceed to fill 50% to 100% of the gap.
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