Beware And Prepare For A Mini Market Flash Crash

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Includes: DIA, QQQ, SPY
by: John Tobey, CFA

Fire warning signSmokey the Bear’s fire indicator is pointing to “Danger!” To me, the stock market’s conditions are like a tinder-dry forest. While we cannot know if a spark will ignite a fire, we can beware and prepare for the possibility.

Personal note: I dislike scare tactics in investing. It’s easier to frighten investors than to reassure them. My reason for writing this article is that there is an unusual confluence of conditions that could create a panic selling period. I am not recommending selling – stock valuations and prospects don’t warrant it. However, there are two strategies that need consideration: One is a potential money-loser, the other is a potential money-maker.

The potential sell-off conditions

Monday’s sell-off has taken the stock market once again back to its apparent support level. This “here-we-go-again” performance puts the market in a somewhat precarious condition that can be envisioned by imagining what would happen if that technical barrier fails to hold.

DJIA chart

(Chart courtesy of StockCharts.com)

One comparison to note: Last year’s flash crash occurred just prior to the mega-fear period that took the market down for about two months. This year’s situation is the possibility of a sell-off at the end (I believe) of the mega-fear period. In that way, a drop now could be more akin to last year’s July sell-off – a mini-flash crash.

As I described in my previous write-up, such a breakdown likely would be popularly viewed as proof of fundamental deterioration, not as a buying opportunity. Traders would exacerbate the situation by shifting from using the previous support level as a floor for buying to a ceiling for selling. Add in the widespread negative feelings and the willingness of large institutional investors to control risk by “hedging” (think short-selling) and we have the ingredients for a panicky type of sell-off.

Now let’s talk about how to avoid getting trampled and even how to gain from such an occurrence.

Beware: Using sell-stop orders for protection

The flash crash provided extreme proof that sell-stop orders carry price risk. I presume readers understand how stop orders work – that once a price is hit or surpassed, the order turns into a market order, meaning the execution price is whatever the market determines.

Now, 17 months after the flash crash, some financial advisers are again using these orders for “protection” against a further price decline. However, in a rapid drop, the sell price can end up being well below the stop price. The safer approach is to use a stop-limit sell order, where the price must be at least at the limit level. While the risk is that the order doesn’t get filled, the benefit is that it doesn’t get filled at a poor price, as happened during the flash crash.

Prepare: Using limit-buy orders for opportunity

To take advantage of such a sell-off if it occurs, we can place limit-buy orders at desirable prices. The reason for placing the orders in advance is that such sell-offs can be short-lived, reversing quickly.

The “risk” is that the sell-off doesn’t occur and the stock market rises from its current level. That’s why my preference is to be invested at today’s attractive valuations but be willing to allocate a bit more to stocks if a fire sale occurs.

The bottom line

An unusual confluence of conditions has raised the possibility of a sharp sell-off. If it happens, I expect it will be short-lived because those conditions appear to be stretched to the negative, meaning a quick snap-back followed by even higher prices could occur.

The possibility of this scenario means we need to avoid being taken out of positions at low prices – so, beware of sell-stop orders. Conversely, we could gain by having buy-limit orders in place for good stocks at low prices.

Disclosure: Positions held: Long U.S. stocks and U.S. stock funds