When the Market's Insane, Don't Forget the Basics

Gary focuses on two strategies to use during chaotic times.
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With this market doing its version lately of Rock 'Em, Sock 'Em Robots, it's probably a good time to go over two basics to help keep your powder dry and your sanity intact.

Basic #1:

The market has no knowledge of your individual position. Here's a question I get a lot: "I'm long XYZ, which I bought at 150. It's now at 100. Should I hold? I mean, isn't XYZ bound to go up?"

Implied in this question, of course, is that XYZ almost has to go up, since it's been down so much! As if the market remembers that hey, you bought it at 150, so you're due for a rebound.

To bring some objectivity to the table, however, what you should do is break the trade down into odds and percentages. As an example, let's say you invested 150K in XYZ. Therefore, it's now worth 100K, meaning you're down 50K. And of course, right or wrong, you'd like to get back to even.

So, in essence, you now want your 100K of equity to earn 50% or 50K.

Okay, that's the goal. The next step is your options, and here's where the mind plays funny tricks. Essentially, you have two choices. You can leave your 100K with XYZ and hope it goes back up 50%. Or, you can

invest in any other stock in the universe

and hope that goes up 50%.

The trick your mind plays, of course, is that it conveniently forgets about choice No. 2. No, it thinks it somehow has to stick it out with the doggy XYZ.

As a real-life example, let's look at two stocks:

America Online

(AOL)

, which I reviewed this past

Friday, and

4 Kids Entertainment

(KIDE)

. Let's say AOL was your real-life XYZ and you had ridden it down 33% (meaning you'd need a 50% bounce to get you back to break-even). Unfortunately, there are probably a few people in that situation.

So, on July 27, you look over your options, and go through the aforementioned exercise. Hmmm, are the odds in your favor that AOL will spring back up 50%? Or is there another, stronger stock that has a better shot at rising?

Ah, your eye spies KIDE, and you decide that the

Pokemon

craze is for real, the stock has been strong, and it even broke recently from congestion. So, you take your 100K and buy 2,836 shares of KIDE. Wow, a few days later, those shares are already up 33%! Meanwhile, AOL is down another 13%.

Yes, I know, I went back and found one strong and one weak stock to make my argument look good. But, my point is that there are always alternatives. Usually better alternatives to the dog you're holding now. If you think XYZ will rally, then stick it out. But, if you think there's at least one other stronger stock, then switch horses for a while. Really, the market won't mind.

Basic #2:

It's okay to scratch a trade. Let me give you a recent example that ticked me off, but in retrospect worked out okay. It's not often I daytrade, but in multiple-day down markets, I am always looking for pockets of strength, or favorite stocks that have stopped going down.

Therefore, about a week ago, while the

Nasdaq

was getting mauled, Microsoft

(MSFT) - Get Report

refused to budge. Now on the first telecast of "TheStreet.com" TV show, I was bearish on this stock and up to that point, had the good fortune to be correct. However, I just knew the

Cramers

of the world, plus everyone else, would be looking to bottom-fish Mister Softee, especially after a multiday decline.

Therefore, while I was watching my quote screen and its sea of red, only MSFT stood out with green numbers. I figured if it could stay strong, it was worth at least a daytrade, and I hoped to catch a point or so. Therefore, about midday, I saw the stock take out some resistance (using five-minute bars) on heavy volume, and decided to go long at 85 1/4. The stock moved sideways, and then sure enough, continued on up.

Now with daytrades, a good technique to use is a trendline as a trailing stop. I simply connected the first few lows I had, and then continued the line on up. (As the real time chart updates, the trendline is continued automatically.)

Damn, MSFT looked good, and I thought if it could take out 86, I was home free. It was just about that time, though, that MSFT and just about every other tech stock got nailed, and in a five-minute period, my trend line was broached with the bid sitting back at 85 1/4.

Now, I could have hesitated, rationalized or paused for a bit, but instead I just sold my shares at the market, losing only the commission. Sometimes, yes, they do indeed come back. But this time it didn't, and MSFT finished the day down a teeny at 84 3/4.

Bottom line: I had a strategy, I had some risk control in place and it didn't work out. Being willing to scratch the trade, rather than be stubborn, saved me 1/2 a point. And in this kind of market, with no positive momentum on your side, you want to err on the side of scratching 20 trades in a row, rather than riding down even one for a huge loss.

So, two strategies that are easy to illustrate, hard to implement. But, try them out. In tough markets like we have, they're the kinds of ideas that will keep you in the ball game. And oftentimes that's the best you can hope for.

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@ibm.net.