Chapter 20. The Blowup
Predicting the unpredictable is the great challenge in trading. It is impossible to be correct all the time, and this is why you implement a system that gives you a slight edge. I have had many profitable months where on review I learned that I had just about the same number of losing trades as I did winning trades. In fact, my winning percentage has sometimes been below my losing percentage and yet I have still managed to eek out profitability.
As a trader, your goal is to execute a system that doesn’t seek to eliminate losing trades but rather contain them in a manageable way. It is a system that attempts to capitalize on incremental gains over time while allowing at least a portion of your winning trades to run to their full potential. When executed properly, it will give you a consistently rising equity curve while keeping you sane in the process.
Unfortunately, there will still be times when, regardless of how well you execute, an event occurs in an extraordinary move you did not see coming. I call this the blowup. It has happened to every great trader, and as long as you continue down this path, it will happen to you.
One of the tenets of technical analysis is the idea that somewhere someone always knows something that is not yet public. Due to the human emotions of fear and greed, shared by us all, the desire to capitalize on this knowledge becomes far too tempting. It is why you should never be surprised when an unexpected news piece confirms a move that has already taken place. For example, numerous times in my career, I have seen a stock advance wildly despite a negative market. Day after day, the general market may fall while the resiliency of the individual stock stays strong. Even to the novice, it is clear that something is transpiring under the surface that has not yet been made public. Finally, after days or weeks, the news is released that the company is being acquired or that a favorable ruling has come down or maybe even a new product gets launched. I have also seen individual stocks act extremely poor prior to a negative news piece many times, again confirming this price action only after it has already begun. It is not your job to question why this is happening. It is your job to utilize this information to your advantage.
I am often challenged on this subject because people are reluctant to accept the truth that the market will always give you clues in advance, prior to its move. The greatest example I can share of late was the order-routing problem that sparked an intraday 1,000-point drop in the market early in 2010. Most people were taken by great surprise, and countless investors lost fortunes during the slide. Truth be told, the general market had not been acting well far ahead of this debacle and was giving the astute trader more than enough warning signs to step aside. So that I wouldn’t get caught in a surprise intraday crash, I was positioned short and capitalized on the fall. Of course, you can never be short enough when a big drop comes, as was the case with me that day. However, it was once again an example of the market talking far before the event transpired.
The blowup is different and comes with no technical warning whatsoever. It is when you have executed your plan extremely well yet something goes wrong and the price action moves significantly in the wrong direction for you. This can happen for a variety of reasons. I have seen companies recall products, face fraud charges, miss earnings, disclose accounting issues, lose contracts, fire executives, or be acquired altogether. All of these resulted in a massive reversal of stock price in an instant.
I believe understanding that this can happen and is part of the game is the first step. As mentioned before, it has happened to all the great traders, and it will happen to you. The question, however, is this: How do you handle the situation when the blowup comes your way?
Nothing is worse than realizing you are on the losing end of a blowup. The loss on the individual trade is far greater than you expected. The pit in your stomach feels like a bowling ball just dropped into it, and the notion of sucking your thumb while hiding under your desk suddenly sounds like it would make for a great day. It makes no difference how you have been trading leading up to the blowup. The event serves as an immediate hit, not only to the financial account but also to the emotional tank.
Through the years, I have learned that when the blowup ensues your natural tendency is to freeze. You begin by hoping the blowup reverses course and that your misfortune will be restored (and so you take no action at all). You immediately are stuck in a hope trade and will more than likely begin watching each and every tick of the stock in question. Your zombie-like state will not only paralyze you from taking action on the particular stock but will hinder you from playing any other areas. Like most things in trading, I believe coming in with a plan already established is the key to not letting a blowup do any lasting damage.
My plan for handling a blowup has evolved over time. My primary goal has remained the same: remove the position as quickly as possible so that I can psychologically and financially accept the loss. After the position has been removed, I then move forward looking to repair the financial damage in other areas. Whenever I face a blowup, I immediately take off one-half of the position. It makes no difference to me why the blowup has transpired. I do not argue with the price action in front of me. Nor do I add money to this position seeking to improve my price. Several years ago, when blowups transpired, I sought to remove the entire position immediately. Over time, I noticed that whereas most stocks never returned to where they were before the blowup, some did improve from their initial price immediately following the blowup. Based on this observation, I decided to hold at least one-half throughout the day with the goal of removing the balance at day’s end.
It makes absolutely no difference to me where the stock is trading after the blowup occurs. I want out of the name by day’s end. I never adjust my trading plan when something transpires that wasn’t originally suggested in the chart. To pursue this path would be the beginning of my demise.
Once the position has been removed from the account, I no longer review the stock. In many instances, the stock in question quickly repairs all the damage in short order. If you become infatuated with the price action of your blowup stock after you have moved out, you run the risk of remaining emotionally attached. If you see the stock bounce back significantly, you might hesitate the next time this happens, hoping for a similar outcome. Unfortunately, your hesitation might lead to even greater financial deterioration that cannot be quickly and easily repaired.
I have also witnessed several occasions where the stock in question never returns to the pre-blowup price, and in many instances the company even goes out of business. My goal as a trader is to be always in motion, seeking new opportunities for my capital. I do not want to endlessly torture myself by watching a stock that is dead money.
It always amazes me how quickly I can repair the financial damage once the blowup stock has been removed. Throughout my career, I have been on the losing end of a blowup on many occasions, and you will as well. However, I have been able to overcome the obstacle each time. My rule in handling the blowup remains firm and simple, and I encourage you to adopt a similar method.
Of course, you can incorporate some nuance into your trading to seek to limit the number of blowup instances. Throughout the years, I have collected and implemented several ancillary rules I live by in my day-to-day trading. These rules have helped me avoid blowups significantly and may be something to consider for your trading, as well.
Earnings
Four times a year, publicly traded companies are required by law to report earnings. At these times, the market can resemble a casino. Depending on the mood of the market at the time, stocks may be rewarded handsomely or punished severely. It is not enough just to assume that if a company reports better-than-expected earnings its stock will subsequently rise. Nor is it a safe assumption that a company reporting a worse-than-expected quarterly result will be punished. You must get into the habit of checking when your stocks report so as to not be caught off guard. A company’s earnings report is usually a catalyst for a large move, and your success should never depend on guessing this outcome.
My rule is simple. I never hold more than one-third of a full position in a stock through a company’s earnings announcement. This remains true regardless of where I am in the trade at the time. In fact, I prefer to not hold any shares at all and will pass on a trading opportunity if I see their earnings release is too close to the date for which I’m pondering the trade.
Adhering to this rule allows me to avoid potentially damaging results. Earnings season is a breeding ground for blowups, and I would rather avoid these if I have the choice.
As you trade, you might be tempted to gamble on an earnings report of a specific company. I strongly encourage you to avoid this at all costs. Regardless of whether your opinion is correct, it can easily breed a bad habit, which, if allowed to take hold, can prove extremely damaging.
I am always amused when I see someone making a big bet on an earnings announcement. I am even more amused when I see someone boasting of success, as if some sort of skill set allowed the person to capitalize on the opportunity. I shake my head, knowing it is only a matter of time before this person becomes just another statistic on the failure of traders in the marketplace.
Special Events
Similar to earnings announcements, there will be certain times a special event will become a market-moving catalyst. This may be an FOMC (Federal Open Market Committee) meeting, an employment report, or a government change. It will be very clear this event will have the power to move the market and alter stock prices significantly. It is my rule to reduce my exposure dramatically prior to this taking place.
I view these events much like gambling, with very little edge for the astute trader. Rather than bet on the outcome, I prefer to see how the action transpires. Once the news is known and digested, I can again assess the landscape and seek out new opportunities.
Biotechnology
Over the years, I have become increasingly wary of one particular stock group: biotechnology. Biotechnology seeks to blend medicine with technological advancements and is often a playground for intense speculation. The group is governed by the FDA (Food and Drug Administration), which has the power to make or break a company overnight.
I have seen companies advance several thousand percent on the heels of a favorable FDA ruling, just as I have seen a company lose 70% of its market cap on a negative ruling.
At times, the potential for gains is enticing, but I generally choose to avoid the sector altogether. For every solid winner, it has been my experience that there are four or five terrible losers. Most of the time, the charts of these companies give you little hint about their next movement, with the most bullish turning extremely bearish and vice versa.
I have yet to regret not playing this sector, and on many instances have been thankful that I stayed away. I would consider removing this group from your playlist and avoid the potential for great disaster through the next biotech blowup.
As time progresses, there may be new areas or events to consider avoiding. As a trader, you must embrace the fact that one trade should never be able to make or break your account. Let others travel this dangerous path while you simply grind out consistent gains in a boring manner.