In my daily report for Waverly Advisors I issued a short-term buy on the Nikkei 225 futures. Obviously, this is a controversial trade fraught with difficulty, but I thought it might be interesting to think about this type of situation from a technical perspective.

First of all, please read the link above. Before reducing the situation to a set of technical principles, it is only appropriate to pause and consider the human tragedy associated with this market movement. Though I would not call myself a “socially responsible investor” or something like that, I do have some psychological issues relating to profiting from so much suffering. The last time I really ran into this was about a year ago, trading Massey Energy in the premarket after the explosion. In my opinion, if you’re a professional trader or money manager you just have to get over these issues and make the right trades, but it doesn’t mean you have to be callous and disrespectful.

With that as background, let’s consider some broad principles:

• Equity markets tend to overreact to disasters and other “acts of God”. This is not the same as someone randomly buying a stock which is down 5% or 10% (that, in my opinion, is just silly without other supporting factors). When a major index takes a major hit, it is usually being driven by panic and margin calls. In this kind of emotional situation, investors do not make rational decisions so prices tend to overshoot. In the case of an individual stock, it is certainly possible the stock will continue on its merry way to oblivion, with the requisite stop at the pink sheets, but this is much, much less likely in the case of a major index.
• Statistics are not that useful here, because the sample size of major events is so small. If you’re interesting in understanding this kind of price action, do a case study of equity market reactions to major events over the past 50 years. You can extend this to other markets, but you need to do your homework. For instance, shorting FCOJ (Frozen Concentrate Orange Juice) Futures when frost damages a portion of the crop is a really efficient way to blow out an account.
• This is not a clean trade. You’re not going to get in and then get out when some technical level is violated. I don’t understand the fundamental impact of the disaster, and neither do you, so don’t speculate about it. Trade what you see. The only way I have found to trade events like this is to buy a small position, set an unthinkable stop, and then move it a little further away. Of course, you have motivation to set as tight a stop as possible (= larger position size), but you have to be prepared for the collapse to go further than you ever expected, and need to save some bullets to buy more lower.
• There is also a good argument for not rushing in. In situations like this, the second mouse often gets the cheese. If you’re in early, you gotta be in small.
• I don’t think you can make a trade like this in an ETF (EWJ, etc) because you cannot be locked out of the market while US markets are closed. This is a recipe for disaster, and highlights one of the major ways that ETF products fail.
• Lastly, I would suggest you spend a lot of time thinking about how a trade like this might play out. Perhaps the disaster is worse than expected and the market drops much faster and further than expected. In this case, you take a loss on the trade, but it was a “normal” size loss and well-calculated. Fine, we lose on about half our trades anyway, so this is no problem. Perhaps the market bounces back very strongly. How do you manage that? Exit all? Exit some and hold the rest for long term? Exit some and then buy back lower? Consider all the possibilities. Perhaps the market makes a reluctant bounce. Could this be the classic “dead cat bounce”, which is actually something more akin to a bear flag? These types of situations often retest the extreme low, so stopping out right at the low is usually not a great idea. How are you going to manage the trade? How are you going to manage the risk?

This is a valid technical trade, but it is a difficult one.  Anyone thinking about making a trade like this should have done their homework in advance, and have a mental template for how you are going to handle situations like this.  Above all, the key element is properly understanding and managing the risk in the trade while maintaining the proper degree of exposure to price movements.