8 trading strategies for a stock market crash

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).

Interview with Shah Gilani

The following is an interview I had with Capital Wave Forecast editor and former hedge fund manager Shah Gilani:

Q: What are the chances for a true crash?

Gilani: A potential for a crash always looms out there. Unless the Fed comes to the rescue, we could get what didn’t happen last year. Last year, a crash was staved off because of the QE2 announcements. Ironically, the market was down 256 points almost to the day last year. We’ll have to see if the Fed comes to the rescue this year. Unfortunately, we never know which card the Fed is playing. It’s like a game of Three-card Monte.

Q: What would happen if the Fed intervenes?

Gilani: The markets could take off if that happens. People might be thinking: I missed last year. It could be like hearing a starter pistol, and the train is the Fed with a handful of cash. So people would jump back in, and we could see a big pop in the market. If you’ve got the backing of the Fed, you jump in with both feet.

The market has gone up because of the monetary stimulus since February 2009. Where did that stimulus go? It didn’t go to building infrastructure. It was used to bail out the banks. The Fed gave the money to the banks so they could rebuild their balance sheets. The Fed wanted the banks to get healthy again. And where did all that short term money go? To the stock market! And to buying commodities. The Fed engineered a stock market recovery. The idea was to create confidence and improve investor sentiment.

Q: Is there a downside to QE3?

Gilani: The downside is if the Fed threw a party and no one came. The negative is if it doesn’t work.

Q: What strategies should you use?

Gilani: First, you should be nimble. Read economic data. Everyday it comes out, read it. Be quick on the trigger and get out. If the Fed makes a move, get out of that train and switch gears.

If you’re an investor, you have to be defensive. There is always time to make money and to get back in. It’s now a stock picker’s market. I want to be in stocks that have plenty of cash flow, has global reach, and supports a nice, fat dividend. I’m not looking for high flyers but stability and preservation of capital.

Q: What else should you buy?

Gilani: If you have money, apply it to strong, international companies with good dividend yields. I like Merck, Rathion, and Microsoft.

Q: Are you nervous about September and October?

Gilani: Always! Especially this September and October. If the Fed doesn’t come in soon, I’d be concerned if the economy doesn’t show better numbers, and if the global markets slow down and pull back.

Interview with Timothy Sykes: Part II

The following is an interview I had with blogger and professional short-seller Timothy Sykes:

Q: What should someone do right now?

Sykes: The odds favor doing nothing right now. The downside is so massive. If we can’t hold 11,000, it could start momentum. It could be a 10% off sale and people could pile in.

Q: What is so important about Dow 11,000?

Sykes: If 11,000 cracks, then we can see some true panic. Remember, this is just August. We didn’t plan on this. In all likelihood, this is just a precursor to a lot of trouble heading into September and October. We raised the debt ceiling but it’s only good to the end of the year. All we did was stall the inevitable. I don’t expect us to rebound to the highs and break out. Right now, all the momentum players are scared. You can be a dip buyer and make a few points here and there.

Q: Should you short this market?

Sykes: I never short market drops because it’s so difficult. Right now, it’s tough to short down here. The only angle I see is selectively buying strong stocks. You buy into strength and you short into individual strength. I short sell individual stocks that are being manipulated, but I don’t short the whole market.

I also like to trade overreactions. I find that whichever way the market is going, it tends to overreact. So I think we’re going to overreact on the downside. If we overreact in a bull market, people spend more because they’re happier. You have to be extra careful when the market is going down, like now, because a crash could lead to a depression.

Q: How about going long?

Sykes: I wouldn’t build long-term positions on either side right now. It’s better if you trade like a sniper, and be picky. The market is volatile right now. The fundamentals are saying we’re doing great, but the economy is saying we’re doing poorly. On the technical side, the charts are saying you should go short, but a long term short has never worked out well. So we have opposing sides. There is no consensus.

Q: What else should you watch out for?

Sykes: Watch out for earnings losers because they will get smacked the most in this environment. Dump any speculative stocks and focus on earnings winners. Stick with companies that have proven themselves. If the market moves higher, these stocks should move higher. Right now I like Rosetta Stone.

Q: What kind of trader are you?

Sykes: I like to 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. By managing my risk carefully and cutting losses quickly, I am not afraid. I’m always thinking of safety first, because it always protects me, even if I miss out on opportunities.

7 ways to identify an imminent market crash

MIAMI (MarketWatch) — For more than two years, people have been warning of an impending stock-market crash. Those who listened buried their money in short-term bonds or cash and missed out on one of the greatest comebacks in market history.

Even with all the problems in the world, the resilient market continues to go higher. Nevertheless, based on recent market action and interviews I’ve conducted with traders, I believe there’s an increased chance the market will drop 10% or 15% before it rises 10% or 15%.

The purpose of this article is to help traders and investors understand the clues and psychological characteristics that often precede a market crash. No one can predict the day or time, but if you pay attention, you can recognize the signals.

Clue no. 1: Leading stocks fall

This comes from “How To Make Money In Stocks” by Investor’s Business Daily founder and Chairman William J. O’Neil. If leading stocks such as Priceline.com Inc., Amazon.com Inc. and Apple Inc. start to break down and fall, this signals that the market is weakening and that the market’s dynamics are changing for the worse.

In addition, after the recent two-year bull market, expect choppy conditions moving forward, which increases the risk there could be a correction or crash. Bottom line: Pay attention to leading stocks.

Clue no. 2: September-October curse

Historically, most crashes occur in September and October. If you’re in the stock market, you must be acutely aware of these two months and be prepared for potential crashes. Because traders with trigger fingers know about the September-October curse, fear often increases during these two volatile months.

Clue no. 3: Speculation is rampant

Who can forget the crazy days of 1999 when Internet stocks like Qualcomm Inc. went up by 100 or more points in a day? My favorite example is the 17th-century tulip mania, when thousands of Dutch people paid more than $200,000 (using today’s exchange rate) for a single tulip bulb.

Although the current market environment is not that speculative, there are clues that some stocks are flying into the stratosphere. “You could make the case that the current valuations of Twitter, Facebook, LinkedIn, Pandora and Zillow are extreme,” says Timothy Sykes, professional trader and short-seller. “These companies have amazing business models and people think their businesses will never stop growing, but that is just bull. The odds are that Facebook’s valuation will see $60 billion valuation (currently $80 billion) before it sees $120 billion.”

Clue no. 4: Media doom and gloom

When the media begin to report that the market has been falling for a record number of days (i.e. “down for fifth straight session”), it makes people anxious. “It causes people to want to exit en masse,” says Sykes, “like a run on the bank. They are being influenced by fear.”

Although the media don’t create news, the cumulative effect of the negative news creates anxiety and fear. It might not take much for millions of investors to throw in the towel and sell. Read my interview with Timothy Sykes on the characteristics and clues that precede market crashes.

In addition to the above clues, it’s also important to study crash characteristics.

Characteristic No. 1: The catalyst

There is usually a big event that takes a weakened market lower. This can be the catalyst that causes the crash.

“Crashes don’t usually happen out of the blue,” according to Sykes. “Sometimes they do, but most crashes occur when the market is already downtrending.” He says that people are already selling into a downtrending market when they “suddenly puke it up one day. The momentum that causes a crash is built up over days, weeks or months.”

The most dangerous market is a long and gradual downtrend where there are no bounces. This can lead to a severe crash.

Note: The current market remains in a two-year uptrend, although it has been struggling lately.

Characteristic No. 2: The big bounce

As you probably know, the two big motivators in the stock market are fear and greed. Although greed can go on indefinitely, most people don’t remain in a perpetual state of fear for long. That is why after a big crash, there is often a big bounce. “Every crash throughout history has been followed by a bounce, no matter how fleeting,” says Sykes. “It might not be huge or long, but if you can sit in cash while everyone else is panicking, you have an opportunity.”

Flash crashes, although rare, can create the biggest bounce, he added.

Characteristic No. 3: Crashes rarely happen at tops

Most people think the market hits some magical number, like the Dow Jones Industrial Average at 13,000, and then crashes. This myth has caused people to miss out on many financial opportunities. “People love calling the top,” says Sykes, “because they think there will be a crash from the top. The market might fail to break out to new highs, but crashes usually don’t happen at the top.”

A more likely scenario, he remarked, is there’s a drop before the crash. “This scares the momentum buyers away, which can then lead to a crash.”

For example, it took 17 months for the blue-chip index to fall from 14,164 in October 2007 to 6,469 in March 2009. The most severe damage to the market lasted only five months beginning on Oct. 1, 2008, when the Dow already had fallen to 10,850.

Understanding the characteristics and clues of market crashes is essential for traders and investors. It’s also important to have a plan before the next crash occurs, which will be the subject of my next article.

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).