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Posted on 20 August 2011 | 8,066 views

18 Trading Strategies for a Stock Market Crash

From August 1 through August 10, when the Standard & Poor’s 500 Index plunged 13.3 percent amid surging volatility, high-frequency firms tripled their volume and may have accounted for 75 percent of U.S. shares changing hands.

Wall Street closed Friday with losses for the fourth straight week as investors pulled out of the market on growing fears that both the U.S. and Europe face a recession.

Hewlett-Packard’s (Ticker Symbol: HPQ) poor forecast caused its stock to drop nearly 20 percent Friday, its worst single day since the stock-market crash of 1987. The company announced Thursday it may spin off its PC business, the biggest in the world.

Stocks also took a hit from the news that the S&P 500 index dropped 13.1 percent and was on track to have its worst month since October 2008. What were seeing right now is basically a crisis of confidence, more so than economic crisis or financial crisis necessarily at this stage.

If a stock market crash is imminent, traders need to know how and when to react — here are several timely strategies to consider.

1. Stop being a know-it-all and shut up

If you are telling people a price or a support line where the selling will end, you are only kidding yourself. Have a guess based on your discipline and research, but don’t act like you’re talking facts. Fair Value is fine, but call it a guideline. Support is also fine, but call it a historical estimate of where buyers have come in before. The deal with stock market crashes is that extremes are the norm, not the exception. Things tend to overshoot through reversion to the mean trendlines or fair value estimates on their way back to stasis.

2. Forget about shorting

For most traders, selling short is too difficult. First, it’s tough to get the timing right. Second, even when you’re right, many rookie short sellers lose all their gains by holding too long. Because people don’t remain in panic mode for very long, there are often big snap-back rallies that can quickly wipe out all your profits. Bottom line: Leave shorting to the pros.

3. Buy on the dip

Rather than sell short during a crash, it’s better to wait and then buy on the dip. As long as you quickly cut losses if the trade doesn’t work out, buying on the dip after a crash can make sense.

“Pullbacks have generally been good buying opportunities for the short term” — If you have money, buy strong, international companies with good dividend yields and have stops everywhere in case your wrong.

Buy on the dip after crashes. “The only angle is selectively buying strong stocks with solid earnings like Apple (Ticker Symbol: AAPL), Priceline (Ticker Symbol: PCLN), and Google (Ticker Symbol: GOOG),” — Focus on strong companies that have proven themselves and if the market moves higher, these leaders will move higher the fastest in a flight to quality.

Rather than short the overall market — short individual stocks. “Because markets tend to overreact on the way down, never short market drops because it’s so difficult.” One strategy is to short weak stocks that have tried but failed to rally.

4. Watch sentiment more closely than technicals or fundamentals

Pay attention to the sentiment in a crash more so than you would normally. Are people screaming in pain? Or are they still looking for a bottom? Or have they given up entirely? There is no math to this, a lot of it is “feel”.

5. Trade like a coward

“It’s not about who can make the most money the quickest, but who can employ risk management techniques to focus on survival and consistent profits” — “The idea is to remain liquid coming into these crashes.”

Cowardly, yes, but not scared — by managing risk carefully and cutting losses quickly, don’t  be afraid.” As a cowardly trader, try moving to 90% cash by the end of the day, and almost always before weekends.

6. Consider put options for protection or profit

Buying put options to protect your stocks can make sense for some traders. When used in this way, you are buying options as a form of insurance. As the stock value goes down, the put option typically rises. If your stocks go up, however, you can lose what you paid for the option.

Some traders may also consider buying put options for speculation, but they would need to be right about the timing as well as the direction. Unfortunately, many option speculators lose money. Another strategy: Before a crash, experienced option traders might consider a long strangle, a sophisticated strategy that takes advantage of extreme market conditions.

7. Be careful in September and October

The market so far in August 2011 looks bad enough, but most previous crashes have occurred in September and October. Accordingly, these are considered the two most dangerous months of the year. “In all likelihood, this is just a precursor to a lot of trouble we’ll see in September and October,” because of the market’s recent downturn. “Don’t expect us to rebound to the highs and peak out — if 11,000 cracks, then we can see some true panic — and it already has.”

Be concerned if the economy doesn’t show better numbers by September 2011 and October 2011 — Unless the Fed comes to the rescue, a potential for a crash is looming.” Even if there is QE3 — round three of the Fed’s quantitative easing — be concerned about what would happen if “the Fed threw a party and no one came.”

8. Acknowledge that its a crash

Once we’re past down 10% in the Dow Jones Industrial Average from wherever the peak was (yes, the Dow is a way better crash gauge than the S&P 500), you can stop saying correction and start saying crash. Better to be wrong in hindsight on the nomenclature.

9. Stay on the sidelines

A more conservative strategy during a crash is to simply stay on the sidelines and wait for lower risk and higher reward opportunities. Before and after crashes, emotions are running high and it’s easy to get whipsawed. When markets are too volatile, it’s not the time to be a hero.

10. Make sacrifices by reducing stock exposure by beta and volatility

An iron-clad rule — the moment you recognize the crash, kick out the small caps, biotech’s, emerging markets, etc. You must separate your feelings for a particular asset class, sector or individual stock and recognize that the higher the volatility, the worse they’re gonna act in the short-term. I have a prenuptial agreement with every position I put on and we get divorced cleanly in a crash situation if need be.

Also, margin balances must get cleaned up immediately, take the losses, I don’t care. Because broker-dealers and clearing firms can and will raise equity requirements right at the moment of maximum pain and force you to sell out later — and lower.

11. Be nimble

Because the market is so emotional right now, traders have to be nimble. If you do enter the market, tread cautiously — read economic data and pay attention to the Fed’s moves. “If the Fed makes a move, be ready to ride on that train. Right now, it’s a stockpicker’s market.”

12. Cut losses quickly

Rule No. 1 for traders is to cut losses quickly at a predetermined price. You’ve probably been told to use a hard stop loss to limit losses. Unfortunately, in a fast moving market, stop loss orders often don’t work as advertised. Therefore, disciplined traders may consider initiating a mental stop that is calculated in advance. To close the trade, however, use a limit order (absolutely do not use a market order in a fast-moving market).

13. Pencils Down

Whatever trendlines or individual stock research you were working on needs to be shelved for the moment. Your drawings and calculations will not work here. If you happen to buy a stock and it dips higher, it will not be because of your research, it will be because the market went up. Correlation’s always get jagged in “Stock Market Crashes“, stocks become commoditized like bushels of wheat that must be liquidated regardless of the underlying businesses.

14. Don’t listen to “stockpickers” or sell-side equity analysts

They are only looking out from within their own little bubble and they cannot comprehend the other little bubbles around them let alone the whole bathtub. Anyone covering specific stocks needs to know when the macro gyrations trump whatever earnings they’ve estimated or the conference calls they’ve listened to. There’ll be a time to “know your stocks” but this isn’t it.

15. Ignore brokerage firms — their job is to calm markets and soothe investors

Let’s say Morgan Stanley (Ticker Symbol: MS) runs $1 trillion in stock market wealth for investors. And then let’s say they felt there was serious trouble ahead. Do you really think they would ever make the sell call? Can Morgan Stanley really say “Sell 20% of your equities”? No, because that would be $200 billion in supply hitting the stock market at once — stocks would crash all by themselves!

16. Make two lists

The first list everyone knows about and talks about – the “if they get cheap enough I’ll buy it at that price” shopping list. Fine, but don’t forget the “things I will sell on the next bounce list”. Even the worst markets have short-term bounces in the midst of the chaos, use these bounces to get rid of the things that make you ill on the red days, even if you’re taking a loss. The stocks you bought on a flyer one day or the companies that have been disappointing or where the story has changed – sell them on the dips.

17. Abandon any hope or intention of catching the bottom

You won’t and it is unnecessary — no one will carry you out on their shoulders if you manage to do it but you will definitely get carried out on a stretcher if you get it really wrong with your own capital. Keep in mind that time becomes more important than price — not where will it end but when?

18. Suspend disbelief

“Bank of America (Ticker Symbol: BAC) could NEVER be a $5 stock!” “How could Bear Stearns possibly go out of business, its a hundred-year-old firm!” “No way this stock should trade at 5 times earnings, it’s a Dow component!” “How could the market go down 5% four days in a row?” Anything can happen in a crash, there are machines making the trades and they have no respect for the prestige or standing of a particular company. This is both gut-wrenching to behold and great for the level-headed who eventually got to buy Wells Fargo (Ticker Symbol: WFC) in the teens or Apple (Ticker Symbol: AAPL) in the low $100s once the bottom was in.

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