The market gapped down and fell more than 400 points on February 27, 2007 marking the largest drop since the September 2001 attacks. While the press and pundits analyzed the fall from many angles, there’s been a paucity of comments regarding lessons learned from a traders’ perspective. Here’s our take that combines risk management technology and good old fashion trading plan advice:

• Volatility plays havoc on backtested strategies that are used “rolling forward” – find a backtesting tool that can account for volatility or keep tight stops on your trades
• If your P&L goes red for 3 consecutive days – take a breather from trading and launch an investigation on what’s gone wrong: your plan, your emotional state/judgements, or behavior are prime suspects that are guilty until proven innocent

Imagine a nice placid pond with hardly a ripple on a calm, quiet spring morning … and then all of a sudden taking a boulder and throwing it right in for a big splash.

In essence that is what happened on February 27. Prior to that day, the market was in a fairly normalized uptrend:

“The steepness of the market’s drop, as well as its global breadth, signaled a possible correction after a long period of stable and steadily rising stock markets that had not been shaken by such a volatile day of trading in several years.”
Stocks Have Worst Day Since 9/11 Attacks, AP/Yahoo News

When the markets experience such a day – all bets were off with regard to trendlines and what can happen next. Why? Days like these impact traders significantly because trading systems that use previous day(s) behavior in their screens and other set-up criteria immediately stop functioning and force a trader to go back to the drawing board.

Model for Volatility When Backtesting

Figure 1.0 illustrates several points of extreme volatility on a daily chart from January 9 to April 3rd of this year. This type of volatility is analogous to trying to surf the biggest waves on the planet – to stay afloat you better know what you are doing. Look at the span that covers the month of March. Our Odds Maker analysis showed a month where the predictability of systems was virtually non existent.

March, looking back, would have been a great time to sit and watch. If you can’t read the tea leaves yourself, read the daily musings of TraderMike and follow his lead – often times its right on the money (look at his useful Trend Table at the bottom).

Even with TraderMike’s crystal ball, it’s still crucial to manage risk no matter what. In the face of very high volatility it is better to err on the side of caution and keep stops very tight – or even better – know the Volume Weighted Volatility for the stocks you are trading (see AAPL’s VWV). To assist traders with the kind of volatility March gave us, we introduce additions to The Odds Maker which allows traders to enter any type of stop into a trading system. See the middle column “Profit Target/Stop Loss” in Figure 2.0 for a picture of what the new Odds Maker configuration menu looks like. (This new capability in The Odds Maker arrives ‘shortly’.)

Three Strikes and You’re Out

Another rule that we suggest is the consecutive days down rule. If you find that you are down 3 days in a row in your trading, it is time to take a day off and a serious look at where the problem could be hiding. Sometimes taking that little time off is what is really needed to get a trader off of the losing path and back on the right track. When losing days pile on, the emotions tend to get the better of us. It is better to know that ahead of time and have a course of action.

Kenny Rogers appropriately sang the lyrics of, “You better know when to hold ’em, know when to fold ’em, know when to walk away and know when to run”. Follow age-old trading plan rules and use innovative risk management technology – the combination will protect you from bad habits and bad trading situations.