What should you do if either the stock market should collapse or a single stock you own does?
Imagine you own a stock that month on month extending over several years produces a consistently rising share price. In the space of two and a half years you have a 900% return. You see the price double in a year, but on one particular day, the stock has dropped 40% compared to the previous day. A full year’s worth of gains erased in a few hours. What does an online trader do?
The culprit under scrutiny is not exactly a fly by night high risk penny share company.
However, the sharp share price fall could have been in any company, and most people will have experienced this difficult situation I was recently faced with. Only now do I feel able to talk about it – after much psychotherapy. The cause of the fall, as is often the case with such events, was an earnings announcement.
Choices in a Stock Market Collapse
An online trader in this situation has three choices. You can buy more stock, do nothing, or sell out. The argument for buying more stock could be that it is now ‘cheaper’, that such an unusually large drop may have been a market over-reaction and represent a buying opportunity.
I do not consider buying more to be a good idea after such a traumatic event to the stock price. If I have bought the stock based on certain criteria, such as expectations about growth, earnings, profits, then I would now be buying this stock right after an announcement telling me that I was wrong.
In any event, a buy decision on any stock should also be based on a comparison to opportunities elsewhere. A company having made a negatively interpreted earnings announcement is rarely going to be one of the best buy opportunities around.
The second option is to do nothing. This may well be attractive if I had bought the stock to buy and hold until retirement. You see I feel life is too short to buy and hold until the day before I die, and spend the money on my death-bed.
The danger of doing nothing in this situation is that we are choosing to ignore a very important piece of market information. Buy and hold is one thing, buy and hope is quite different.
Option three is to sell some or all of the holdings. This is a difficult choice for most traders because, as Pat Arbor the former Chairman of the Chicago Board of Trade explains in The Mind of a Trader, ‘a loss is not just a loss of money but a blow to the ego’. Needless to say I do not suffer from such ego problems!
as Pat Arbor the former Chairman of the Chicago Board of Trade explains in The Mind of a Trader, ‘a loss is not just a loss of money but a blow to the ego’. Needless to say I do not suffer from such ego problems!
Managing Your Ego In a Market Collapse
A loss is also difficult to face because many traders feel that they need to win on every trade. The important thing is not the number of winners you have, but how much money you make. They two are not always directly linked. I know many traders who win nine trades in a row only to lose on the tenth all the previous nine gains.
But how does one know whether the stock has fallen to the point where it should be sold? There are many reasons why one may wish to sell a stock, but there is one over-riding rule that should be used in order to limit downside risk. The rule, taken this time from Bill Lipschutz, former Global Head of Forex at Salomon Brothers presented in The Mind of a Trader, is to only risk about 2% of your total trading capital on any single trade.
For instance, if you have £20,000 to trade with, and divide that into 20 portions of £1000 in order to reduce risk through diversification, then you should not suffer a loss greater than £200 on any single £1000 trade. That is because £200 is 2% of your total trading capital of £20,000. With the downside protected, you could go through prolonged losing streaks without the fear that you will exhaust your capital. Again, a buy and holder may well just hold on.
Learn to Love Your Small Losses
Equally important to learning to love your small losses, so you can redeploy the capital into a more fruitful trading opportunity, is to learn something from those losses – after all if I have paid the market something, I sure want to get some value out of the expense.
So what did I learn from such falls? Perhaps more analysis? Well, the company where this happens more often than not had revenue growth that doubled the previous year, decreasing expenses year on year, increasing operating income, reduced debt and interest expenditure thereby increased earnings per chare each year resulting in strong share price growth.
An important lesson I was reminded of was that expectations drive prices, even for very profitable companies. If earning miss expectations then even if they and revenue, assets etc. grow, the price can drop. But that is trading for beginners, there was a more important lesson.
Price jumps because what occurred was unexpected. The unexpected by definition is very difficult to, well, expect. It is unforeseeable, and that is why once it occurred the price jumped downwards. The ultimate lesson from this was that ‘**it happens’, so deal with it. Follow the 2% rule to limit risk. Of course you are free to try sell well before facing a 2% loss, the rule is just an absolute bottom line to protect trading capital.