Dealing with Price Shocks

02/04/2015 6:00 am EST

Focus: STRATEGIES

Perry Kaufman

Author, Trading Systems and Method

By citing a few stocks as examples, Perry Kaufman, of KaufmanSignals.com, outlines two methods for how to trade, deal, and cope with those ugly—but not so uncommon—price shock events.

Our programs saw two exceptionally large price shocks during January, the Swiss franc in futures mid-month and Hawaiian Holdings (HA) on the last day of the month. That makes it a good time to discuss these ugly, but not so unusual events. What can we do to reduce the loss? And why do they always go against us? Why do most price shocks cause losses for the majority of investors? Because we are mostly long equities and there is a void of liquidity selling on unexpected news. For futures, we tend to hold positions in the direction of the trend, along with everyone else. When good news is a surprise, the price moves far less.

First, let’s look at some information about price shocks. We’re going to identify a shock as a day in which the high or low is more than 3.5 ATRs (Average True Range) above the average ATR, so if the normal range of AAPL is about $3 (trading at $115), then we need an intraday move of $10.50 to trigger a shock. We did the same for SPY, using a factor of 3.0. SPY would be less volatile because it’s the average of many stocks. The charts below show the most extreme move of the day, in percentage, and the closing percentage change on the same day. Many of the shocks in AAPL seem to revert during the day, while not as much for SPY. We would venture to say that a shock in SPY is one affecting the whole market and may be more structural, such as poor overall economic news. Still, when averaged, a typical pullback from the extreme to the close is 28% for Apple and 24% for SPY.

chart
Click to Enlarge

Since 2000, about 15 years, there have been 40-50 price shocks in each market, that’s about three per year. Apple shows six over 15%, although when we think of the spectacular rise in AAPL prices, we don’t remember those days. New highs seem to make past risks less important.

What can be done to reduce the loss on those days? That’s a tricky question. By definition, a price shock is unexpected, so studying old price data is, for the most part, meaningless. Can we use a stop-loss? Stops work if the price keeps going, but experience tells us that we normally get out at a terrible price, then we see some recovery by the close, so if you’re going to exit, then the close is better than an intraday stop order. But then, if you’re a trend follower and have a very large profit in AAPL or HA and a price shock takes away 10% in a day, is that important? If you get out, but the trend is still up, you might miss the next 50% gain. How do you decide when to get back in? The best solution is to have a system that includes risk controls, which could even be a simple moving average where you exit when the trend changes and follow those rules.

Rather than doubling down and hoping for a reversal, there are two other ways to reduce the loss of a price shock. Naturally, the first is diversification. If one stock drops 20% and it’s only one of 20 stocks that your trade, then the net effect is a loss of 1%. That’s a lot better. The other is to have a trading strategy that is out of the market more often. If your method is only exposed 25% of the time, you have a 75% chance of missing the price shock. We see those as the best choices.

By Perry Kaufman, Founder and Editor, KaufmanSignals.com

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