Price Shock

The Smart Profits Report: Issue #359
Wednesday, October 4, 2006

Price Shock: How To Respond To Three Types Of Price Shock During Earnings Season
By D.R. Barton, Jr.
Advisory Panelist, Mt. Vernon Research

In the stock market, price shocks - unpredictable moves that are too fast to trade - are one of the toughest and least understood parts of trading. They’re the market’s equivalent of a low blow - and the market loves to take cheap shots.

The problem is that nobody is immune. A series of price shocks (along with poor risk management) even crippled the most infamous hedge fund of all time, Long Term Capital Management.

Watching For Several Forms of Price Shocks

Price shocks show up in several forms, the most prevalent of which is the overnight gap. All investors are familiar with this ugly scenario, where a company reports bad news, and the stock promptly gets hammered.

One of the cases I remember most was biotech stock Human Genome Sciences (Nasdaq: HGSI). I was following the stock closely and it was a year ago exactly that the company happened to report disappointing clinical trial results for one of its products after the market closed. The next morning, the stock opened down nearly 30%.

Price shocks occur much more often than we imagine. And while it’s not always easy to see them coming, there are steps you can take to mitigate the effect and even take advantage when they occur in our favor - particularly now that another earnings season is about to kick off. That means the market is sure to be more active and under some pressure, as companies report third quarter results. It also means that there are going to be many more price shocks, as investors respond to the news.

Your #1 Protection Plan: Position Sizing

Understand that whenever a negative price shock occurs, the horse has already left the barn, so to speak. So it’s imperative that you’re prepared for this in advance.

Therefore, the most important thing you can do today is make sure your position size for each trade protects you. That’s why we recommend you put no more than 1 to 2% of your account equity at risk on any single trade or investment. If you follow this prudent risk-management strategy, you’ll be prepared for the worst-case price shock scenario, and protected from a catastrophic loss.

How To Respond To Three Types Of Price Shock

What we need is a systematic approach for dealing with price shocks in managing our portfolios, whether they have had a negative or positive effect on our account. So here’s how to combat three common types of price shock.

Major Structural Or Fundamental Change:

Price shocks that have concrete reasons are the easiest to understand. These are the announcements that will clearly have lasting effects on an asset. After the price shock, the price typically continues to move in the same direction. For example, if a company comes under SEC investigation, it will get a negative price shock that is not likely to retrace any time soon. If this happens to one of your holdings, exit the position.

On the other hand, a takeover target or a company that is already receiving bids from multiple companies - or is in the process of being bought - usually sees a positive price shock that is not likely to be reversed.

There are two ways to play this. If you’re aggressive, you can hold the position in hopes of the expected continuing move. But a more conservative approach would be to take profits on half of your position, especially if you are not certain about your analysis.

Overreaction To A Move That Had A Sound Basis:

Price shocks often cause overreactions. People tend to punish bad news more than is warranted or reward good news above and beyond what is reasonable. This is especially true if the news only affects a limited time frame. Events like quarterly earnings and new contracts typically move the price, but do not have a structural, long-term effect.

The same can be said for weather-related news and its effect on commodity prices. After this price shock, the price usually retraces. A great example was the effect that Hurricane Katrina had on oil prices. In the chart below, note the price spike from $65 to $71 as the hurricane approached, followed by a quick retreat the day after the hurricane hit.

Hurricane Katrina's Effect on Oil Prices

If the price moves in your direction: Take profits on at least half, if not all, your position. Many times, the price shock is most extreme move you’ll see and prices will retreat.

If the price moves against you: If you’re not already stopped out, you may be able to hold on for a retracement. This type of news may warrant tightening your stop, and don’t expect to recapture all of what you lost from the shock price move.

Overreaction To Rumors And Other “False” Moves:

Price shocks can happen because of rumors such as takeovers, or strategic alliances. This is the most difficult type of move to identify. After this type of price shock, the price usually retraces all the way to the original price level.

What To Do When Prices Move

If the price moves in your direction: Take the money and run! Many times, you may leave part of the position in place if you can’t make a firm decision on whether you are dealing with rumor or fact.

If the price moves against you: If you’re not already stopped out, hold on for a retracement. Again, this type of news may warrant tightening your stop, but you have a good chance of recapturing your losses.

Good Trading,

D.R. Barton, Jr.

Today’s Smart Profits Cribsheet

When price shocks occur, they hit hard and fast, often wiping out solid gains in just a few minutes. That’s why employing a stop loss policy is imperative to your trading success, so you choose the risk that’s right for you, and are always protected against heavy, unexpected losses. Mt. Vernon Research Chairman Karim Rahemtulla explains how to do this in Smart Profits #133: Trailing Stops: How to Give Your Options Room to Grow.

Do you have any idea what an asian tail option is? No? Then don’t hesitate to immerse yourself in the Smart Profits Glossary, chock full of over 175 options terms and definitions!

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