When the stock market decides to take a tumble, how should you react? Should you hold onto your same positions thinking they will come back, or should you sell everything and run for cover? Every great thing must come to an end, and whether it be temporary or long term you have to be ready at all times. There are tons of different strategies for handling a big sell off in the market, and if played right you'll be dancing in the streets while the others lick their wounds.
Predict and React
This is so huge when it comes to investing successfully for the average investor that you could literally host a seminar on it and spend all day discussing it. The importance of predict and react is to simply have a plan in place that says, "when x event occurs, than I need to react with x NOW".
I don't care how many monitors you have at your trading station and if you boast a $100 million dollar portfolio, you are no future teller with all the answers. Let's be honest, if we could really predict the stock market time after time, day after day, we would all be richer than bill gates. Predicting in the sense of looking into a crystal ball is not predicting at all, but predicting in the sense of using history or events to prepare for potential events is real life.
When it comes to the stock market, there are always signs that come into play, some very obvious and some very hidden that could mean a sell off or price surge is potentially around the corner. With stock market crashes it is about your ability to read the signals, ignore the emotionally driven traders, and follow your own rules. That's prediction.
Once you have your strategy in place and the "signs" have shown themselves to predict a potentially catastrophic event, you need to react. Reacting effectively in the stock market does not mean using emotional buying or selling to your ultimate success or failure, it means simply enacting a plan and sticking to it with discipline.
When it comes to market crashes this normally means liquidating a decent size portion of your portfolio, tightening up stops, and either cutting down from new long positions or completely move to shorting. It doesn't have to be all of these things, but after a few big losses you'll understand why they are in place.
Three Heavy Distribution Days, Go Away
The S & P 500 index excluding today and looking just at Tuedsay through Thursday has lost some 4% in value. Did you know that some traders were already reacting by selling positions and raising stops on Tuesday if not late last week? One of the most effective strategies I have come across and utilized in my own trading comes from investors.com CANSLIM trading style, and the way it is used is simply with the thinking that after three consecutive distribution days with no accumulation, you react and put up your defense.
The S & P 500:
(I want to clarify quickly here that there are other technical indicators within this chart that show signs of weakness and could have possibly predicting price point (4.) but for the sake of this article we are going to focus on solely Distribution days. If you need help understanding distribution days on stock charts, I have written some great articles that you can read, here and heck a quiz here.)
By looking at this chart you can see pretty clearly three heavy distribution days at points (1.), (2.), and (3.). They are considered consecutive in this sense because they were not interrupted by an accumulation day of some sort. With our simple strategy of three distribution days than go away we would have sold out our positions or performed whatever reaction plan we had in place at point (3.) or the morning after.
Strategies for Reacting
Reacting and putting into a action a preset plan is actually a lot of fun, very simple, and unemotional unless you do with it music blaring in a wife beater while smoking a joint and getting high (no I haven't done it before but just imagine the hostility). For the average investor (excluding hedge fund managers, institutions, etc.) there are a few routes you can go which I introduced further up:
Selling Full Positions
Liquidating current positions is a very easy route to go and unless you are trying to hold these stocks to take advantage of long term capital gains, this is an easy call. Using the same 3 distribution days go away strategy from above, on that 3rd day we would have cashed out on positions. How much you cash out is up to you, but some options could be to:
- Sell everything no questions asked - "Sell it all, the world is ending."
- Sell half of your positions - Hold any positions that are in defensive stocks typically unaffected by the market.
This is a fantastic way to prepare for any uncertainties when you want to play your cards tight. Stop loss orders are extremely effective when used correctly, and I am a promoter to almost always have stops on your positions regardless. Why? Because you simply never know what to expect especially in some individual stocks effected by things like earnings, news releases, and the like.
When I say raise stops I am implying you already have stops on your positions. So, integrating this strategy you up your insurance policy to get you cashed out faster if a positions decides to head south.
Selling Part of Positions
Similar to selling a position in its entirety, you can instead sell lets say half of the position and hold the other half to see what happens. This is a very common way to take profits off the table while still maintaining control of what you purchased a while back. With money off the table you can afford to take on the extra risk of your stocks falling with the market.
Another way to react could be to what is called hedging your positions if you don't want to sell them outright. I will not go into hedging here but basically by buying say an ETF that has the inverse effect of the S & P 500 or the NASDAQ 100 (QID) you can than start making money while the market tumbles. Millionaires were made during the 2002 crash and other crashes in history by simply traders shorting or betting that the market and/or individual stocks were going to go down in value. (I also wrote an article explaining shorting)
These are just some of the strategies you can integrate into your "reaction plan" as you could call it when the market is looking unstable. In the end having a solid plan to lean on when things look sour could save you your nest egg and mental stability. A final thought for you to consider is this fact, "3 out of 4 stocks follow the overall market trend" meaning that when the market is going up 75% of stocks are going up with it, and when the market sell off, 75% of stocks sell off with it. It is great making money, but losing money because you are stubborn is no fun. Be smart, always try to predict and react.