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:
The characteristics of market crashes.
1: Leading stocks fall
This comes from “How To Make Money In Stocks” by Investor’s Business Daily, start to break down and fall, this signals that the market is weakening and that the market’s dynamics are changing for the worse.
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.
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.
4. 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. 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).
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