Sunday, May 16, 2010

What to do if your stock falls 50% in a few minutes?

This post is inspired by.....

How do you protect yourself against a fall like this? If you look at the intraday chart for TIVO, it fell within a matter of minutes. If you had a hard stop in place, chances are you got a bad fill. Consider an even worse scenario dear readers. What if a stock in which you hold a long position gaps down over 50%, not even giving you a chance to get out for a decent loss? Can happen. Does happen. Will happen. So, what can you do in such a scenario? Basically, nothing.

But there are ways you can minimize your losses in case this happens. Actually, the key lies in acting properly before it happens. No, I am not asking you to try and predict a fall like this. What I am talking about is proper risk management.

In the end, its ALL about risk management dear readers. Its all about the risk/reward ratio. I like to think that if you take care of the risk, the rewards will take care of themselves.  A very important part of risk management is position sizing. And if I can "implement" position sizing with a small trading account, there is no reason why all you readers can't do so with your accounts. Here is how it would have helped you in a situation like this.

Say, I don't believe in position sizing and I went all in a which stock gaps down 60%. Ouch! Now to break even, I will need 150% profits on my remaining capital! Tough, isn't it?? Could take you years to break even after a loss like this.

Now let's consider the alternative scenario where the maximum I allocate in any position is 10% of my trading capital. That's still a pretty aggressive strategy if I have a large trading account. Again, my stock gaps down 60%. But now, due to my allocating only 10% of my trading capital in this stock, I suffer "only" a 6% loss on my total capital. To breakeven, I need a gain of 6.3% going forward.

150% vs 6.3%. Think about it!


Is It Possible said...

Nice post, but after the facts!!! Lets say I am in the stock already and have incurred the loss although not realized yet. So how can I minimize or overcome this loss now when the stock has moved against me!!!

any ideas!!!

positiontrader said...

I have given your question some thought IIP and IMO, the answer in this case depends on various factors such as the reason for the drop,the volume, the loss to your overall account etc. I will write a detailed post on it in the near future.

But whatever you do, don't average down!! :)