How to Limit Damage From Event Risk

Experienced traders can study the price patterns and read the latest news but still get burned by event risk. It's worth learning how to incorporate this painful influence into your performance expectations.

What exactly is event risk? This simple term refers to unexpected developments that adversely affect your positions. It's a chaos factor that can be stock-specific, such as a major downgrade, or a marketwide shock, such as Hurricane Katrina.

Let's focus on event risk that hits specific stocks. I'll note the most common types of information shock and offer a helpful technique to reduce the negative impact to your bottom line.

Sources of Pain

To start, consider that these painful events usually arrive through one of three potent sources:

Financial institutions shock expectations with downgrades and reduced price targets.
Individual companies move stocks with earnings warnings, secondary offerings and executive departures.
Governments undermine confidence with Food and Drug Administration rejections and Securities and Exchange Commission investigations.

I'll review each of these shock sources in turn.

First, institutional shocks. Most of these come in the premarket environment, with Monday releases meting out the bulk of the pain. A few years ago, only Tier 1 brokers had a significant effect on short-term trading. That's no longer true. Even the smallest boutique firm can trigger a major selloff these days, if the time is right.

The greatest downgrade threat comes after a stock gets stretched to the upside. For example, M-Systems (FLSH - commentary - Cramer's Take) ran 6 points over three weeks and stalled out above $30 earlier this week. C.E. Unterberg Towbin downgraded the stock on Tuesday morning. Although Unterberg Towbin is just a minor player, that didn't stop price from falling almost 2 points that day.

Companies can cause just as much pain; all traders have held stocks that have been ripped apart after earnings warnings. But secondary offerings can trigger equally painful selloffs. This is especially true with small operations, such as junior biotechs, that have questionable balance sheets. The reason: These companies use secondaries to pay salaries, not to expand core operations.

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Alan Farley is a professional trader and author of The Master Swing Trader. Farley also runs a Web site called HardRightEdge.com, an online resource for trading education, technical analysis and short-term investment strategies. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Farley appreciates your feedback; click here to send him an email. Also, click here to sign up for Farley's premium subscription product The Daily Swing Trade brought to you exclusively by TheStreet.com.

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