Surviving the Post-Apocalyptic Market

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The major indices hit new rally highs on April 26, just eight days before a systematic failure dubbed the “flash crash” dropped the Dow Jones Industrial Average nearly 1,000 points in just a few minutes. While the markets bounced as quickly as they fell, the impact of the event still reverberates through the ticker tape over three months later.

According to Barrons, a September report from the Securities and Exchange Commission will conclude that high-frequency trading systems and other institutional traders all backed away on May 6, leaving retailers like you and me to twist in the wind with no quotes to sell. Of course, most of us watching the market that day already know what happened because it was obvious from the bizarre price action.

What we don’t know is how the SEC will restore lost confidence that has triggered a public stampede out of equities in the last three months. Sadly, when it comes to market regulation, this group of regulators is as clueless as were the Bush appointees, and U.S. stocks could get permanently broken if the multiple system failures aren’t fixed soon.

Just consider their initial response, which entailed busting trades that were 60% or more outside the prices posted just before the event. This arbitrary number was clearly designed to have as little impact as possible on the exchanges’ bottom lines. Meanwhile, it’s set to hurt nearly every investor or trader who panicked during the collapse and sold stocks because they suspected a terrorist bombing or a North Korea nuclear launch.

Also consider that this appalling decision destroyed classic risk-management principles that had been in place for generations. As with other trading educators, I tell every student who can’t watch the markets in real time to place stops on all open positions in order to avoid catastrophic losses. This is just good common sense, or so we thought.

We now know those sell orders turned into time bombs on May 6, because there was no liquidity or depth when they got triggered that afternoon. As a result, a huge number of retail players lost a fortune because positions closed out at 40%, 50% and even 59% discounts to prices in force just minutes before the catastrophe.

Many of these folks won’t buy another stock or exchange-traded fund until the SEC and exchanges rebuild confidence in this highly unstable market system. However, that might be an impossible chore. After all, 4,000 points on the Dow in 2009 and early 2010 failed to restore traditional inflows into equities destroyed by the bear market.

The SEC, exchanges and Wall Street want public investors and traders to believe the May 6 event was just a glitch or an aberration that carried little importance, and that it will never, ever happen again. Unfortunately everyone outside of Washington, DC understands that, even with the rumored rule changes, another flash crash is nearly inevitable.

Those of us who earn a living in the financial markets need to recognize this dire threat to our livelihoods, whether it’s a result of speculation or analysis. In a word, despite years of nonsense about level playing fields and cheap market access, the public thinks the game is permanently rigged. As such, they’re getting ready to abandon the markets — and never return.

I believe they’re right, up to a point, because lax regulation and rampaging algorithms have destroyed natural supply and demand. Statistical arbitrage and rebate strategies, instead of fundamental or technical positioning, are now controlling market movement through the lens of unbalanced numbers.

I nevertheless haven’t given up on the market strategies I’ve used successfully for almost two decades now, although it’s been a real tough summer for my bottom line. To respond to this enormous challenge, I’ve made a hundred adjustments to my trading methodologies and firmly believe I’ll prosper once the dust finally settles.

These modifications all fall along a line of risk reduction, with an element of guerilla tactics added into the mix. They furthermore capitalize on the financial markets as they really are in the summer of 2010, rather than addressing a fantasy world that exists in trading tutorials and instructional videos, but not on the real live ticker tape.

In no particular order, here are 10 of the techniques that I’m using to survive this perilous post-apocalyptic environment.

1. More Fibonacci: I’ve noticed that Fibonacci retracements are working unusually well these days, despite seemingly chaotic movement in the major indices.

2. Less Alpha: Exchange-traded funds are yielding better profits than are individual stocks because the technical movement is more predictable.

3. More Beta: I’m trading equity breakouts and breakdowns when the S&P 500 and Nasdaq 100 hit multiday highs or multiday lows, and the rest of the time I stand aside.

4. Less Overnight: I’m doing a ton of day trading and avoid taking positions between 11 a.m. and 2:30 p.m. EDT.

5. More Targeted Risk: I look for just one big play to take home overnight, or over a weekend, instead of buying a basket and risking a reversal in Europe or Asia.

6. Smaller Position Size: I’ve cut down position size across the board and am hitting for singles or doubles, rather than swinging for the fences.

7. More Commodities: I trade more metals, energy and agriculture because the commodity markets haven’t changed much in the last 30 years and the old strategies still work.

8. Less Chasing: I lose money whenever I chase momentum into a position. Therefore, I now spend more time waiting for gaps, magic numbers and “outliers.”

9. More Flipping: Scanning and flipping through the charts is taking twice the usual time because finding profitable needles in the haystack is much harder to do.

10. Less Intermediate: I’ve shut down my position trading account and have taken just two trades since May that I expected to hold for more than two or three days.