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Article What Can You Do When the Markets Go Wild? by D.R. Barton, Jr.
Trading Tip While Everyone Was Nervous, One Great Trader Took 100R from the Market Last Week by Van K. Tharp, Ph.D.
Mail Bag Technical Research Not Resulting in Profits
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What Can You Do When the Markets Go Wild?
The buzz everywhere has been about the crazy market action from last Thursday May 6th.
Many have tried to characterize the day: moves of historic proportions, unprecedented, and, my personal favorite, a 10 sigma occurrence.
The first two are factually accurate. We had the biggest absolute intraday point move in the indexes (there have been larger moves on a percentage basis).
The third observation (10 sigma) is an interesting one. It’s interesting for two reasons: 1) it illustrates how extreme the move truly was, and 2) it shows what happens when we use weak models and unquestioned assumptions.
The concept of 10 sigma events was popularized by Roger Lowenstein’s excellent book When Genius Failed: The Rise and Fall of Long-Term Capital Management. Lowenstein recounts that their models showed that the loss LTCM suffered was a 10 sigma event, meaning that it should statistically happen only once every 1 × 1024 days—which means never.
Most people assume this refers to a Gaussian or normal distribution. To call last Thursday’s move a 10 sigma event makes that same assumption. This normal model (or set of assumptions), however, does not represent market price activity accurately. Most analysts agree that the market is at best normally distributed with kurtosis (fat tails) and outliers. Some analysts would flat out say that market price activity is not normally distributed. Basically, this is a statistical way of saying that extreme events happen more often than can be predicted or really expected.
Rather than discuss the statistical fine points of big market moves, I’d prefer to provoke some thought about what, if anything, we can or should do given the probability of more wild market moves in the current environment. First, though, let’s see if we can get past the headlines to understand what happened.
What Happened Thursday May 6th?
There is, as of yet, no definitive answer as to what happened last Thursday afternoon. There has been no shortage of solutions offered by everyone from the Securities and Exchange Commission to Saturday Night Live. But as far as specific root causes, not much has surfaced.
The current best guess as to what happened involves a market version of “The Perfect Storm”: many smaller components combined to push the system temporarily off the cliff.
We started the day with the markets down in a big way on fears of a Greek financial demise—the broader damage being done to the Euro and European markets. This push had the Dow down 300 points before the fireworks started. Stop orders started getting hit and the Dow dropped to −500 on the day. Then many things happened in rapid succession, none of which by itself caused the collapse but all contributed:
- A high-speed (high frequency) trading company stopped trading to limit losses for the day.
- Large sell or hedging orders were triggered on the futures and options exchanges. Some reports have pointed to a large S&P E-mini futures order (though not the infamous “fat finger” trade—see below) and a large 50,000 contract option order as possible tipping points.
- The NYSE rules hit Liquidity Replenishing Points (LRPs) in many individual stocks and moved to “slow” mode, shutting down electronic trading for those stocks and moving to human market makers only.
- Meanwhile, electronic exchanges like NASDAQ, BATS and others continued trading normally all issues - including the stocks that had hit LRPs and moved to “slow” mode at the NYSE.
- Large stock orders were triggered to sell, including blue chip Proctor & Gamble. P&G didn’t trade at all for 80 seconds on the NYSE floor but traded down significantly in the electronic exchanges.
- Other large pools of liquidity, including additional high frequency trading firms, shut down or minimized operations.
- Bids dried up (there were no buyers) on some individual stocks and some issues trades logged as low as a penny a share.
- With the Dow down over 1,000 points on the day, buyers re-entered the market and erased 70% of the price collapse in 15 – 20 minutes.
Investigators and analysts have yet to find the real tipping point. One of early stories circulating (and recounted on American TV’s Saturday Night Live sketch comedy show) was that a trader “fat fingered” a sell order for $16 billion of S&P e-mini contracts instead of $16 million. This story and other similar ones have largely been discredited.
It’s Not Your Dad’s Stock Market Anymore
Today’s stock market game is different than some years back. After regulations changed (Reg NMS provided open data access to all exchanges), the volume on many blue chips has dropped from 80% on the NYSE just a few years ago to less than 30% today, according to the Wall Street Journal. That means that the majority of trading for P&G, IBM and other household blue chip namesis now goes through the NASDAQ, BATS and other electronic exchanges.
After some experience with market crashes, the NYSE designed trading “circuit breakers” to help relieve some of the problems of fast moving prices. They work fine in theory but today the problem is that more blue chip volume flows through the electronic exchanges—which don’t have circuit breakers systems. What’s apparent now is that the circuit breakers on the NYSE actually exacerbated the problems last week rather than relieved them. Certainly more cooperation and common circuit breaker rules among the exchanges will be one of the outcomes of this chapter in the trading annals.
In addition, estimates reported by the WSJ are that 30% of total stock trading volume is now done by high frequency trading firms. Whether you think they are champions of a free market economy, parasites on society, or something in between, I can’t imagine that the trading firms behind that much volume will be allowed to play along with business as usual in the future. At minimum, some rules concerning market participation are likely to come up so that the liquidity from these channels doesn’t just dry up at the flip of a switch.
A Quick High View
Before diving deeper, I want to scan the 30,000 foot view for just a moment. Lots of funds and many, many retail investors and traders got hurt when stop losses were triggered (almost universally at unfavorable prices with bids drying up). Then with big losses on the page, the markets climbed back in a matter of minutes leaving many perplexed and shell shocked at how they could lose huge money while following the rules of prudent investing and trading and using stop losses.
Fair trading markets are a cornerstone of any modern society. And Thursday’s market gave at least an appearance (not the reality) of being an unfair game that the average investor or trader can’t win. In trying to rectify this situation, let’s hope the regulation pendulum doesn’t swing too far in the direction of control.
Regardless, as traders and investors, the relevant question of the moment is “What do we do about it?”
I’ve heard lots of discussion, especially around stop losses. And I’ve been asked these questions:
- "Should we use close only stop losses?"
- "Should we quit using stop losses at all?"
- "How can I protect myself against big drops like this?"
Proper position sizing remains the MAIN source of risk management for traders and investors. Realizing a loss two or three times bigger than our planned risk amount (-2R or -3R in Van’s terms) should not put our accounts in jeopardy if you have even an inkling about risk management.
Additionally, everyone needs to have some exposure to low correlated positions. If you mainly trade and invest in stocks, consider trading gold and other commodities as well. Even if you had multiple holdings that were completely uncorrelated, each and every one of them requires proper position sizing! Remember, there were almost no safe havens in the fall of 2008.
Let’s finish up by putting last week into perspective. A 10% drop in one day certainly is ugly—but it’s not disastrous. Even if you got stopped out at the bottom of the spike down on Thursday afternoon, you live to trade and invest another day.
Next week I’ll review the thorny issue of intraday stops versus close only stops and try to shine some light on the increasingly difficult trade-offs between the two. Please remember: protecting yourself with stops is still a central part of good trading practice. One event does not make a trading and investing career! Until then, I’d love to hear your thoughts and feedback at drbarton “at” iitm.com.
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While Everyone Was Nervous,
One Great Trader Took 100R from the Market Last Week
Ken Long is one of our best instructors at The Van Tharp Institute and he may have reached "master" status given his consistent performance over the long run and recent outstanding results. Ken always teaches the traders in our workshops to manage the left side of the trade—risk. Sometimes the right side (reward) works out okay and sometimes it works out fantastic, but the focus is always on managing the risk. He did that last week as he always does even as everyone else was concerned about the chaos. We even had one person tell us that he would never keep stops again because he was stopped out of everything on Thursday. Well, in that same week, Ken managed to make 100R.
Let’s look at how he did it. After a large multi-day move down that started about 8 trading days back ($74 range), Ken believed that a stock on his watchlist had overreacted and there was a chance one morning midweek last week that there could be a bounce back up. As he likes to say, “The market never reacts when it can overreact." Ken was watching for signs of a strong bounce up after the open - a very low risk entry. When he saw it, he went long on it for the first time just before 10 AM. As a result of the strength of the move, he entered four times that hour, maintained his normal risk controls and was able to pull 60R out of one trade. That’s truly phenomenal.
In another notable trade last week, Ken pulled in 22R. In addition to his other winning trades (and a few losses, too), Ken finished at 100+R for the week.
Ken fully acknowledges that his results were beyond the range of “normal.” In his own words,
“That 100R week is an anomaly. We did what we always do in the chatroom with good setups and risk control. This keeps in line with the idea that when we carefully control the risk, we leave in place the means for an upside ’catastrophic reward.’ Last week, the market decided to reward us in the moment.”
Regarding my comment on Ken achieving “master” status, he had this to say,
“I prefer to think that I was a pretty good student last week: I did my homework, came to class prepared, listened very carefully, and paid close attention to the tasks at hand. The market is the master and each day we have an opportunity to learn.”
While many of you are scared of this market, I have been saying for some time that the wild markets ahead present numerous opportunities.
Ken Long will be presenting two workshops in June for the Van Tharp Institute. If you want to know how Ken trades and the specifics of his 100R week, be sure to attend.
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Technical Research Not Resulting in Profits
Q: I have been providing technical stock research to institutional money managers for 20 years. I am very good at reading trends and trend dynamics. While this analysis has helped my clients significantly over the years, I have not been able to translate this analysis into consistent profits in my personal trading. Do you have any general advice for someone in my position?
A: Well, fundamentally you can spot when things are out of alignment, but you need to do the following:
- Get your psychology in order so you stop making mistakes.
- Identify your risk when you enter a trade.
- Understand how to control your reward to risk throughout the course of a trade.
- Understand market types. What you do currently won’t work when market conditions change.
- Understand position sizing strategies and their importance in meeting your objectives.
- Write a thorough business plan to guide your trading.
- Develop several good trading systems. Right now, what you think is your system is actually just your "analysis."
In other words, you have to master a lot more of what we teach.
Everything that we do here at the Van Tharp Institute is focused around helping you improve as a trader and investor. Therefore, we love to get your feedback, both positive and negative!
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