If there's one thing a trader fears most, it's a lack of information... especially when it comes to the most basic of all: price.
So I wasn't surprised when all hell broke loose last week when the entire Nasdaq exchange shut down for three hours. "Technical issues" related to price quote dissemination.
Officially, of course, things were under control. But behind the scenes, you've never heard so many creative strings of four-letter words. Between the twitter, chats, instant messaging, and phone calls, the cacophony was telling.
Something big had happened. And the rumor mill ran amok...
Early information suggested it was nothing more than some unsuccessful computer updates. But by afternoon, the "tin-foil hat club" had jumped in, suggesting cyber-terrorism and high-speed-trading misfeeds.
The truth is we may never know what really happened, for two reasons.
That's why I'm going to show you a few simple actions you can take in your brokerage account today, before the next shutdown occurs.
As you'll see, topping off your "stock-market antifreeze" isn't just a defensive move...
The "Battle for Pennies" Accounts for 70% of Volume Now
An estimated 70% of total stock market volume is now computerized. The screaming and shouting you see on TV behind earnest-looking newscasters is but a fraction of what really goes on. Every exchange these days has electronic offshoots, and the combination of floor trading and electronic trading makes for some mind-boggling gyrations.
For example, thanks to the advent of computers and the speed at which they trade, there are roughly 7 to 10 bids and asks placed for every single trade. This means that on a billion-share day, there were roughly 7 to 10 billion orders placed, then taken down, moved, or changed as computers do battle with each other - often for mere pennies.
Then there are the dark pools.
These are special exchanges that never see the light of day. Originally intended for large institutions to "cross" huge positions at specific prices that would otherwise disturb the normal transactional balance of the public exchanges, they've morphed into highly secretive exchanges characterized by large block trading that's total invisible to the investing public.
But first, let's return to last Thursday's freeze.
There are two reasons we may never know exactly what caused the crash:
- Nasdaq has no idea what actually caused it, and - as of press time - is grasping at straws. Right now, they're pointing fingers at a "connectivity" problem with the NYSE's ARCA - a rival exchange. If this is accurate, techies should have been able to control it. If it's not, something else is at work. Nasdaq CEO Bob Greifeld's bumbling appearance on Fox Business Network didn't exactly inspire confidence.
- The breakdown exposed critical flaws and vulnerabilities in the electronic mess that regulators have allowed to flourish behind our exchanges in the name of innovation. This moves the findings squarely into the national security ballpark, which means that at some level the specifics of what actually went down are going to be classified.
My own personal belief is that this was no accident.
The events leading up to the freeze are consistent with a classic "denial of service" attack. Perhaps it was some eight-year-old programmer playing games or something far more sinister. We'll never know - unfortunately, the world is filled with folks who would love to send America over the edge, and they're getting more and more clever about finding the Achilles' heels that make their twisted dreams possible.
I also believe that this calamity reinforces the need for comprehensive, fundamental market reform, as well as comprehensive safeguards against electronic trading that goes awry, regardless of why.
Naturally, the financial exchanges and electronic firms are mounting loud arguments against both, so I'll be curious to see what they say in the next few weeks. It's hard to imagine they'll have a leg to stand on, given that this is yet another in a long string of technology-related failures ranging from the BATS IPO to the Facebook (Nasdaq: FB) debacle and "flash crashes."
Either way, here's what this means for your money. Our money...
There Are Three Moves You Can Make Today
Believe it or not, there's plenty you can do to defend your hard-earned investments against this nonsense.
1. Start using trailing stops... on everything you own, every day.
Trailing stops are fixed orders that help you manage risk by automatically harvesting gains in the event of temporary pullbacks and protecting your capital by cutting off small losses before they become catastrophic.
Most brokerage firms actually have these built into their online platforms at this point, so there's no excuse, in my mind, for not using them - if you're serious about investing, at least, like we are here at Money Morning.
A lot of people ask me all the time whether trailing stops are still a good idea following events like this, because the electronic trading overwhelms the old-fashioned human intervention that would have stopped it a few years ago.
That's a valid question. Research shows that, even though they are not perfect, investors are better off using trailing stops over time, which is why I continue to advocate them.
The other thing to bear in mind - pardon the pun - is that the amount of pressure being brought upon erroneous pricing related to flash crashes and events like the freeze is likely to result in "voiding," as was the case in the most recent crash.
Everybody knows Google (Nasdaq: GOOG) isn't worth $2, so the exchanges are under significant legal and political pressure to void any transactions taking place well beyond otherwise normal ranges. There are no guarantees, but the impetus is there.
2. Take advantage of put options.
More active investors use put options to protect their holdings. These contracts can be married to specific positions or used to protect an entire portfolio.
For example, if you own an S&P 500 Index fund, you can buy SPY put options that increase in value as the markets decline. Most of the big, liquid stocks
have options, so this, too, is an easy fix. But many smaller stocks don't. So if you're worried about a decline, and you like to trade penny stocks without options, I'd encourage you to rethink what you're doing.
3. Consider inverse funds.
You have a lot of specialized inverse funds at your disposal today. These move up when the markets go down. And like put options, they can be as specialized or as general as you want.
For example, there's the RYURX, which zigs as the S&P 500 zags. And the PSQ, which moves opposite the tech-laden QQQs.
Research suggests that having between 3% and 5% of total investable assets in such non-correlated holdings will provide meaningful diversification while also dramatically stabilizing your portfolio.
One caveat: Unless you have a very specific, short-term trading objective, stay away from so-called "leveraged" inverse funds. Generally speaking, these aren't what they're cracked up to be because the leverage induces a tracking error that reduces performance the longer you hold them.
Trying to time the markets may sometimes seem like a good idea; no doubt it's appealing after episodes like last week's "big freeze." But it's a fool's errand.
DALBAR Research shows that timing can lead to underperformance of 200%, 300%, and even 500% or more over time. As my grandfather, who played baseball in the 1920s, used to put it: "You miss 100% of the swings you never take." So why wouldn't you step up to the plate, so to speak?
The other thing to keep in mind is that flash crashes, war, assassinations, Black Monday - even trading glitches - these are all short-term influencers. If anything, be prepared to buy when everything goes "on sale."
Longer term, there is a constantly increasing flood of capital chasing fewer and fewer quality holdings, which means the markets have a pronounced upward bias. So the real key to success is learning how to defend yourself against the kind of electronic nonsense that led to last week's halt and stay in the game.
Fortunately, that's not too difficult using the tools I've just mentioned.