Plan for Extremes In Stock Price Behavior

By Dr. Winton Felt

As either an investor or trader you must train yourself to imagine extreme price behavior.  For example, the stock could rise gradually, split, rise more, split, and so on till your shares are worth 100 times their original cost or more.  The stock could also spike up to ten times their original cost in a day or two and then spike down to less than one-tenth their original cost.  The stock could also drift sideways with little price variation for five years or more..  

Imagine and plan for the best and worst possible outcomes.  Think especially of extreme scenarios.  Suppose the stock runs wild and multiplies 10 times.  Suppose the stock experiences a selling frenzy and becomes worthless.  Imagining the possibilities will help you to practice contingency thinking and risk management.  How would you handle it if the stock suddenly surged 20% in a day?  Would you sell?  Would you think that since it moved up 20% so quickly it probably will rise further and therefore put off any thought of selling right away?  Of course you could protect your gains by using a trailing stop loss.  Where would you put it?  Would you put it below today's low, yesterday's low, or the low of the day before yesterday"?  Would you put it a certain percent below the highest high achieved since your purchase?  If the stock has little price change after a few weeks will you keep holding or will you sell?  If you intend to use time stops, how much non-performance will you tolerate and for how long? 

You should think these things through even before you buy the stock.  Enter your thoughts about different scenarios in your trading diary.  They don't have to be extensive notes.  Just a few words will do.  The point is that if you keep a trading diary and you make notes on how you will react to different scenarios, then you will have actually thought through your response to anything the stock does.  For the expert trader, of course, scenario thinking is automatic and so are his responses.  It is the beginner who must train himself to have a plan--always.

For example, we know of one trader who bought an S&P500 Index option.  Within a half-hour the option doubled.  He was so surprised that he merely stared in disbelief.  After about five minutes he tried to sell.  By the time he entered his order, the option had given up all the gain.  He simply broke even.  Another trader bought a stock for $10 and saw it rise to $17 in one day.  By the end of the day it was back below her purchase price.  The speed with which these positions rose was deceptive.  It is natural to assume that if an investment can double in a day that it will do more in two or three days.  The most common thought is "let's see what happens next."  This kind of price action seduces a person into inactivity.  If either of these people had thought through the scenarios, they might have been better prepared.  They were both told by more experienced traders to sell while their positions were near their highs, but they both refused to act quickly. 

Our own stockdisciplines.com traders always have an exit strategy before they buy.  They have thought through so many scenarios that their responses to different price developments do not require the kind of analysis they once required.  The more often a person thinks through scenarios, the more reflexive his responses will be.  Think of the katas practiced by students of karate.  Those katas are practiced so that the movements will become automatic and reflexive.  In an emergency, the practitioner of karate will be able to respond without thinking.  Simply put, the time it takes to think through your reaction to a price development may be more time than you have.