How to Turn a Crash Into a Buying Opportunity for 15 Dow Stocks

NEW YORK (TheStreet) -- On Aug. 24, General Electric (GE) , Home Depot (HD) and JPMorgan Chase (JPM) had flash crash opens that pushed them down by an unreasonable percentage of 21%. Here's what happened and how you can position yourself to profit next time.

Wall Street knew that the U.S. stock market would open significantly lower that day following the continuing crash of the Shanghai Composite in China. However, the New York Stock Exchange was not prepared for the panic-type open that followed what the Chinese called "Black Monday."

Some say that the New York Stock Exchange implemented what's called Rule 48, which allows designated market makers to open the stock market without broadcasting initial bid and ask prices before the opening bell. As a result, many stocks opened much lower that what can be called fair execution prices. At the opening low, the Dow Jones Industrial Average was down 1,089 points or 6.6%, and the S&P 500 was down by 5.3%.

Jim Cramer explained last week's price action on Friday's "Mad Money" on CNBC. The lesson learned is to never enter a market order to buy or sell. The strategy I recommend is to place good-till-canceled limit orders to buy weakness or to sell strength to a set price or range of prices.

I'll show how large the bid-ask spreads were on stocks at the open during last Monday's crash, and how you can avoid getting burned on such large spreads between what sellers are willing to take and buyers are willing to pay.

This five-minute bar chart of the S&P 500 shows the plunge and recovery from Aug. 21 to Aug. 28.


Courtesy of MetaStock Xenith

From the close of 1,970.89 on Friday, Aug. 21, the S&P 500 plunged by 5.3% to as low as 1,867.01 within the first 10 minutes of trading on Monday, Aug. 24. This low was re-tested at the low of Aug. 25.

All told, 15 of the 30 Dow components had flash crash lows down between 10.5% and 21.3%.

These 15 stocks were allowed to trade lower by more than 10%. The table below shows the ticker, date and time, opening price, high price, low price, last price and volume for the first and second five-minute intervals.

Courtesy of MetaStock Xenith

This data clearly shows how market orders to sell could not find fair prices, and how high-frequency trading platforms executed orders at flash-crash levels. This is evidence that if specialists were still in place, the open might have been at more appropriate execution prices. Instead, the order book was virtually unknown.

The table below shows the July 31 closing prices, the percent changes month-to-date, the Aug. 21 closes, the Aug. 31 closes, the percent change since Aug. 21, the Aug. 24 crash low, the percent crash from the Aug. 21 close, the Aug. 25 secondary low, the percent change from the Aug. 24 low, the percent change from the Aug. 25 low, and the percent difference between the Aug. 25 low and the Aug. 24 low.

Here's the explanation for the three stocks with the largest flash crashes and their weekly charts.

General Electric had a close of $24.82 on Aug. 31, down 4.9% for the month. The stock experienced a flash-crash plunge of 21.2% from the Aug. 21 close of $24.59 to the flash crash low of $19.37 set with the first five minutes of Aug. 24, when 10.2 million shares changed hands.

The range for the first 10 minutes of trading was $19.37 to $23.18, a spread of 20% for a blue chip stock. This range seems more likely to be an annual range. The secondary low for GE was set at $23.27 on Aug. 25. The difference between the Aug. 24 low and the Aug. 25 low was an unrealistic spread of 20.1%.

Courtesy of MetaStock Xenith

The weekly chart for General Electric clearly shows that last week's bar chart is out-of-bounds. The stock should never had traded below its 200-week simple moving average of $23.62.

Other stocks showed the same pattern. Home Depot had a close of $116.46 on Aug. 31, down 0.5% but up 0.4% for the month. The stock experienced a flash-crash plunge of 20.7% from the Aug. 21 close of $116.16 to the flash-crash low of $92.17 set with the first five minutes of Aug. 24, when 1.6 million shares changed hands.

The range for the first 10 minutes of trading was $92.17 to $111.91, a spread of 21% for this blue chip stock. The secondary low for Home Depot was $110.89, set on Aug. 25. The difference between the Aug. 24 low and the Aug. 25 low was an unrealistic spread of 20.3%.

Courtesy of MetaStock Xenith

The weekly chart for Home Depot clearly shows that last week's bar chart is out-of-bounds. The stock stayed well above its 200-week simple moving average of $77.42.

JPMorgan Chase showed a similar pattern. The stock had a close of $64.10 on Aug. 31, down 6.5% for the month to date. The stock experienced a flash-crash plunge of 21.3% from the Aug. 21 close of $63.60 to the flash-crash low of $50.07 set with the first five minutes of Aug. 24, when 2.8 million shares changed hands.

The range for the first 10 minutes of trading was $50.07 to $60.34, a spread of 21% for the largest U.S. money center bank. The secondary low for JPMorgan was $59.73, set on Aug. 25. The difference between the Aug. 24 low and the Aug. 25 low is a ridiculous spread of 19.3%.


Courtesy of MetaStock Xenith

The weekly chart for JP Morgan clearly shows that last week's bar chart is out-of-bounds. The stock should never have traded below its 200-week simple moving average of $51.54.

So what can investors do? Traders who had the imagination to have a good-till-canceled limit order to buy weakness to the 200-week SMA smiled all the way to the bank.

Back in May 2010, the U.S. stock market also experienced flash crash -- a quick, deep and volatile decline in stock prices in a short period of time. The flash crash of May 6, 2010, came by complete surprise and caused the Dow Jones Industrial Average to decline by more than 1,000 points and then recover within 15 minutes. Almost all bogus trades were canceled before settlement. The alleged perpetrator of the crash may soon face a U.S. extradition hearing.

Here's the weekly chart for Procter & Gamble  (PG), which still shows its May 2010 flash crash low.

This sore thumb will show up clearly on the weekly charts for the 15 Dow components for months and years to come. But by using good-till-canceled limit orders instead of buying at market prices, investors can protect themselves even in a flash crash.


Courtesy of MetaStock Xenith

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.

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