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Planning for the Worst

What to do when the market turns against you: A checklist.

About 25 years ago, when I was just a young lad, I took up racquetball. This was right about the time only a few people were playing; even finding a suitable court was a challenge. I mean, if you wanted to play, you basically had either the handball courts at your local YMCA or JCC.

But, I enjoyed it immensely, and played nearly nonstop for years. For those of you who can remember those early days of racquetball, I started with the heavy wooden racquet, graduated to the aluminum

Ektelon

, and kept right on playing until balls lasted more than one game, and graphite racquets were

de rigueur

.

And during that time, I got pretty good. In fact, very good. At least in my small world of Allentown, Pa.

So, armed with my "superior" skill, I ventured down to Philadelphia to play in the biggest tournament around, the

Philadelphia Open

. Players from all over the East Coast were there; and there I was, pumped to be playing the number-one seed in the entire tournament in the first round.

I still remember his name, Rueben Gonzales. Well, we shook hands and proceeded to warm up, each on his half of the court. Of course, I sneaked a few looks at Rueben, and honestly, he didn't look like much. Certainly not a lot of power, and I was thinking, if he's the number-one seed, I'm a shoo-in to win this thing.

I never scored a point. Rueben wasn't fast. "Fast" doesn't describe his speed. No, he was in some parallel universe where time stands still. And power? When his shots hit the front wall, they sounded like mortar blasts.

And the annoying thing was that he didn't even need the power nor the speed, because his shots only knew how to nail that area on the front wall one inch above the floor. On three straight serves of mine, he rolled out his returns. A worm couldn't have fielded them.

Not that this was embarrassing or anything. I mean it was only about 250 people crowded around the glass side and back walls of the court watching me get dissected like some lab experiment.

Humiliating is what it was, but at least I learned something. I learned that I was so far out of my league, even being in the same city with Gonzales was a joke. Really, I had no idea anyone could be so good at any sport! (Rueben, of course, went on to win the tournament in a walk. He later turned pro and won the

U.S. Open

TheStreet Recommends

. At least I wasn't whupped by some nobody!)

So, I slunk back to Allentown, and tried to put some of what I learned to good use. I never approached even 1/10th of Gonzales' ability, but at least I got better. And, I guess if you're not on top, that's the real point.

Market Drops Can Be Great Teachers, Too

Now, what does all this have to do with recent events? Well, for many of you, you've just been on the court with my friend, Rueben. And maybe you scored. Or maybe you got shut out. Regardless of how you fared, I'm willing to bet just about everyone learned something. And, like I said earlier, until you're on top -- and as a trader, you never want to think like that anyway -- learning is what it's all about.

So, I don't know what you learned, but I encourage you to spend a few peaceful moments writing down your thoughts from the past few weeks. I did and came up with a list of things I either learned, or relearned. Here they are:

    You have to decide early in your trading career how much you're going to blend fundamentals and technical analysis. I'm probably 99% TA, 1% fundamentals, but that may not be right for you. Really, it doesn't matter, though, as long as you're consistent. Yes, that's the important part. You can't go back and forth thinking you hate the charts, but rationalizing your positions by saying you love the companies, if loving the companies never mattered before. This concept is important no matter when you're trading, but particularly important during crunch time. You absolutely have to know ahead of time what your blend is, so you can make cool, calm decisions in the face of disaster.

    You must have a disaster plan. Many people holding highfliers thought they had the confidence to hold their stocks through any and all dips. However, the market has a way of not only exposing our weaknesses, but exploiting those weaknesses until we can't stand it any longer. And then we're in a situation of reacting, not acting. Therefore, you must plan ahead and think what to do if your stock bounds ahead 80%, or bounds down 80%. And you have to have this plan in place before you need to execute it. It's been helpful to me over the years to always think worst case, not best case. Generally, the best case takes care of itself. It's up to me to tend to the worst case.

    You must get used to not dawdling. When you make a decision, try to execute it without a continuing debate on the pros and cons. You will always be able to find reasons to stay in a position, or abandon a position. But, if you're acting and not reacting, usually your first instinct is your best instinct. Learn how to pull the trigger.

    Always make the market prove itself. In Friday's column, I drew a chart of the Nasdaq indicating it was in a bear market. And I will keep playing it that way until there is some show of strength like the upper trendline being broken. If the market proves me wrong, I will gladly put on my bull hat. But, not one moment sooner.

    Bear market rallies are fast, huge, and overwhelming. Few of us have been in a bear market. I know I haven't. But, I've studied enough charts, and read enough interviews that I knew a bear-market rally could be the ultimate fakeout. But, even I was not prepared for how strong they could actually be, and it was very, very tempting for me to get sucked in. How to not to get sucked in? Go back and look through my column of last Wednesday. Notice, that in spite of the strength, very few stocks broke their downward trendlines? And even fewer built any kind of base. That's why those rules for going long in a bear market can be helpful.

    Turn off the blow-by-blow TV. Maybe it's me, but all I ever seem to hear are Pollyannas or Doomsdayers. Neither are especially helpful, because everything you really need to make a decision is probably staring you in the face.

    It's OK to get out. Particularly if you're worried. Look, the market doesn't always come back. Or, maybe it comes back yet again, perhaps by the time you read this. Great, I can live with that. But, what if it doesn't? Are you going to draw your equity down to zero so you can make a point? Now, I'm not saying, in fact, to get out, only that it's okay to get out if it's causing you some sleepless nights. Believe me, there will always be time to get back in. Always.

    Your stock has no memory. I've made this point in a number of columns, but it's worth repeating. Let's say you started with $50,000 in stock Moonshot.com. But, Moonshot got shot, and is now down 80%, leaving you with $10,000. Therefore, the question I often get is "Should I sell my Moonshot, or keep it in the hopes it will come back?" However, the real question is: does your remaining $10,000 have a better shot of appreciating in Moonshot or any other stock available. Generally, it's the latter...

    Realize the importance of your broker. Many of you learned that saving a few dollars on commissions didn't help a whole lot when you couldn't log onto your broker's Web site. Therefore, if your account equity is such that even a few minutes of delay or downtime could be extremely costly, then consider either a switch in brokers, or a backup broker. For my story on this, see my " Penny Wise, Pound Foolish" series.

    Trading is just harder in a bear market. Why? Okay, let's rule out going long. My experience is that, much as weak stocks get dragged up in a bull market, even strong stocks get dragged down in a bear market. So, that leaves going short. But, that's not easy either because of the violence of the downside moves. Shorting after almost any big down day, greatly heightens the possibility of being short...right before a huge rally back up. So, that leaves either going short when a stock is in congestion, or going short as a stock is rising. And neither is particularly easy to do. So, what you end up doing is just sitting around in cash, and even that's no cakewalk as many traders feel they have to be doing something nearly every day.

    Don't guess. This is probably the lesson many of you learned or will learn last. It's certainly a lesson I continue to learn. Look, most of the time none of us really knows what's going to happen in the market. But, we at least have a hypothesis and trade off that hypothesis. But, there are other times we are absolutely clueless. I mean, we really have no conception of where the market or our stocks are headed. It's during those times that it's probably best to just step aside until you are clear about what's happening. Because when you're not clear, but you're still trading, you end up having no conviction in your actions. And that's when you start screwing up. And that can be costly.

    So, that's my list, more or less. This match your list? Probably not, so get started with your own. The market may continue to go down, or it may go up. But, whatever direction, it's sure provided us with a great learning opportunity.

    Gary B. Smith is a freelance writer who trades for his own account from his Maryland home using technical analysis. At time of publication, he held no positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Smith writes five technical analysis columns for TheStreet.com each week, including Technician's Take, Charted Territory and TSC Technical Forum. While he cannot provide investment advice or recommendations, he welcomes your feedback at

    gbsmith@attglobal.net.