How to Check Your Head (When Everyone's Losing Theirs)

This past year has been one crisis after another. Failing economies. Battling politicians. Debt crises. High unemployment. Falling interest rates. Take your pick. Market commentators and talking heads have used any and all of these—and then some—to explain why the stocks are down. If it bleeds, it leads, even in financial news. But how can an investor sort out—or throw out—all this information? How do you keep your head when everyone else seems to be losing theirs?

The one thing you don't want to be is a “weak hand"—the person who panics when the market moves lower and who usually has two things working against them:

1. Their positions are too big for their account or risk tolerance.

2. They're overleveraged and have to exit positions—usually at a loss—to avoid margin calls.

The weak hand at the table also doesn't have a real strategy. Buying stocks and hoping they go up--and panicking when the market is volatile—isn't a strategy. And maybe worst of all, the weak hand is buffeted by the constant stream of financial and economic news and every uptick and downtick in the market.

Trading the Noise

To a trader, this is all noise. Markets go up, and markets go down. Volatility is a fact of market life. The “why” isn't nearly as important as the “what.” Most stocks go down when the market's crashing. Good stocks and bad stocks. Good CEOs and bad CEOs. All the analysis in the world about what a “good” investment is won't do you much good in a crash. So, data won't save you. You need to focus on trading results using a pragmatic analysis of what you're going to do in a crash instead of just data-driven analysis. In other words, you need to synthesize what you see happening in the market and use that to create a smart trading or investment strategy. Do that, and you won't be the weak hand at the table.

1) First, don't just “look” at the market. Take note and “see” the market. Sometimes, one or two commodities get everyone's attention and lead the market. Gold and Treasury bonds were big news in 2011. If the S&P 500 futures (the “SPUs") are down, is gold down? Bonds, too? Are you getting confirmation from a rise in volatility? If oil and bonds are down and vol is stagnant, then S&P futures being down is a little unusual.

Forget the news (the “why"), and look at the downside risk in the market (the “what"). Have the SPUs been rallying every day for a week? Then maybe a bull has to be cautious—the downside risk might be a little too big. But if the SPUs are down sharply, volatility isn't spiking, bonds are up only a little and gold is weak, this might be the end of the decline and might be a time to buy. While you do this in about 90 seconds, everyone else is watching the news for 90 minutes, trying to figure out why the SPUs are down. You are seeing the market and synthesizing the live information!

2) When you look at a chart, don't stop with your technical analysis. How much downside or upside is there really in a stock or index? If you look at the lows made during the crash of 2008, that's what can happen when just about everything goes wrong. If your stock's down, how close is it to that 2008/2009 low? (See Figure 1 below.) The theoretical maximum risk of a long stock position is achieved if the stock goes to zero. But how many times do major stocks go to $0? OK, Lehman Brothers, Bear Stearns, GM. Name some more. It gets a little hard. Particularly if you look at stocks in the Dow Industrials or the S&P 500. Is it possible? Sure. So, during a selloff, look at some of the stocks’ lows during that crash.

3) Look at what the options are telling you if they're available for a stock. Are the option values at strikes near those previous lows 0 bid at .05? Then the market doesn't see a lot of possibilities that the stock will get to that level anytime soon. If the options are, say, .20 or .30 or .40 or higher, then yes, the market thinks there's a higher probability that will happen. Sure, the stock can make a move to and past those higher or lower boundaries, but it's a question of probability. Anything's possible, but is it likely? What you're trying to do is estimate the probable range of a stock or index, and if there is more upside in that range than downside. It's not exact. It's not about a stock being “cheap” or “expensive". It's just trying to use the information the whole market is giving you to make a more informed decision and hopefully get the odds on your side.

Rubber, Meet Road

In practice, there are a few things you can do to cut through the noise a little faster and easier. One strategy may be to trade and invest in products with liquidity. Liquidity describes how quickly you can enter or exit a trade at a “fair” price. I might be willing to pay .01 or.02 more when buying or take .01 or .02 less when selling, but not much more. A liquid product lets me do that. An illiquid product means that I may have to give up a lot more in order to execute an order. And an illiquid product with a wide bid/ask spread in a calm market is going to be even less liquid with wider bid/ask spreads when the market's collapsing. How can you check liquidity? It's pretty straightforward.

1) Search for penny increments. If you fire up the thinkorswim platform, on the Market Watch tab, in the Quotes sub tab, open up the “Penny Increment Options” list from the “Public” menu. That starts you out by showing only symbols with options that trade in .01 increments. That's a good place to start because the options that trade in .01 increments tend to be a bit more actively traded and have narrower bid/ask spreads.

2) Next, sort by volume. Take your list and sort by the volume column, from high to low by simply clicking on the column header “volume.” That shows you the stocks with the most number of shares traded today. [NOTE : You can drill down a bit further if you want, by creating a Scan Query on the Quote sub tab. When you do that you can scan for “Penny Increment Options” and have that list intersect with, say, the S&P 500 or NASDAQ 100, for example. That will show you the symbols for stocks that are components of those major indices that have options with tighter bid/ask spreads. Then you can sort by volume to see the most actively traded stocks with options that trade in .01 increments.]

3) Check open interest. As a final check on liquidity, you can go to the thinkorswim Trade page to see the volume and open interest for a stock's options. The most liquid options trade thousands of contracts a day and have tens of thousands of contracts in open interest. But even if the stock you're looking at has options that trade a few hundred contracts a day and have a few thousand in open interest, you're still probably looking at pretty liquid options.

By the way, if you'd rather trade another stock in the same sector, but you don't know which sector it's in, just go back to the MarketWatch tab, then the Quotes sub tab. Next, add in the columns Industry Division, Industry Group, and Industry Sector. When you type your symbol onto that Quote page, you'll see what part of the market it resides. Then go to the Watch sub tab (also under the MarketWatch tab), and drill down into the Index Watch section. When you select a watch list from the drop down menu, look in the Industry menu. You can follow the Division, Group and Sector of your original stock to find other stocks in that category. Then check those stocks’ liquidity. If one is much more liquid than the other, you might think about replacing your original stock with a more liquid competitor.

Stocks With High Vol

You can also view stocks whose options have a higher-than-normal volatility. That means the stock's options have higher premiums than they normally do. When you work with short-option strategies such as cash-secured short puts, short call or put verticals, the higher volatility increases the credit you can take in when you do those trades. That extra premium means your potential profit is increased, and the risk of the position might be lower. You can do that on the MarketWatch tab, Quotes sub tab fairly easily. Create a custom column with this formula:

Plot data = highest(imp_volatility, 262)/imp_volatility;

That displays the ratio of the highest level that implied vol has been for a stock and the current implied vol. The closer that number is to 1, the higher the current implied volatility is to previous highs. Bear in mind, this number is always greater than or equal to 1. Since we're approaching 1 from a higher value, lower numbers are better.

Breakout Stocks

Finally, check out stocks that might be getting close to a 52-week high or low. Is that a magic number? No, but if you're bullish on the market, for example, a stock near a 52-week low, some feel it might be a candidate for a bounce higher. The opposite is true if you're bearish on the market and a stock near its 52-week high. Some feel it might be a candidate for a move lower. You can see how far away stocks are from their 52-week (or any other time period, for that matter) high or low using the custom column feature on the Quote sub tab of the MarketWatch tab. Create a custom column with this formula:

Plot data = close/lowest(low, 262);

That column will show you the ratio of the current stock price to the lowest price in the last 262 trading days (about 52 weeks). The closer that number is to 1.00, the closer the current stock price is to the 52 week low.

Let's face it. Weak hands don't have a good reason for doing what they do when markets fall. Typically, they panic because they're trading too big relative to account size or they're over-leveraged on margin. If you're acting out of fear with very little rationale, it's probably not your stock—it's your strategy. These strategies are really just the beginning, but hopefully, you'll start to take a common-sense approach to trading volatile markets.