MIAMI, Fla. (MarketWatch) — While the U.S. market’s tumble feels like a crash, so far it’s closer to a correction, though an extreme one. Still, market psychology has been hit hard, and it wouldn’t take much to stoke selling panic and capitulation.
If a crash is imminent, traders need to know how and when to react. Here are several timely strategies to consider.
It would also be helpful to read an article I wrote last week about the characteristics and clues of market crashes: Read more: The characteristics of market crashes.
1. 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.
2. 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,” said former hedge fund manager Shah Gilani. “If you have money, you’d buy strong, international companies with good dividend yields. That being said, I have stops everywhere in case I’m wrong.” Read more: Full interview with Shah Gilani.
Short-seller Timothy Sykes also buys on the dip after crashes. “The only angle I see is selectively buying strong stocks with solid earnings like Apple, Priceline, and Google,” Sykes said. “Focus on strong companies that have proven themselves. If the market moves higher, these leaders will move higher the fastest in a flight to quality.”
Rather than short the overall market, Sykes shorts individual stocks. “Because markets tend to overreact on the way down, I never short market drops because it’s so difficult.” His usual strategy is to short weak stocks that have tried but failed to rally. Read more: Full interview with Sykes.
3. 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,” Sykes said. “The idea is to remain liquid coming into these crashes.”
Cowardly, yes, but not scared. Said Sykes: “By managing my risk carefully and cutting losses quickly, I am not afraid.” As a cowardly trader, he often moves to 90% cash by the end of the day, and almost always before weekends.
4. 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’d 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.
5. Be careful in September and October
The market so far in August 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,” Sykes said of the market’s recent downturn. “I don’t expect us to rebound to the highs and break out. If 11,000 cracks, then we can see some true panic.”
Gilani added: “I’d be concerned if the economy doesn’t show better numbers by September and October. 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 — Gilani said he’s concerned about what would happen if “the Fed threw a party and no one came.”
6. 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.
7. Be nimble
Because the market is so emotional right now, traders have to be nimble. If you do enter the market, tread cautiously. Gilani suggests that you 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 stock picker’s market.”
8. 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).
Michael Sincere is the author of Start Day Trading Now (Adams Media, 2011), All About Market Indicators (McGraw-Hill, 2010), and Understanding Stocks (McGraw-Hill, 2003).