I remember seeing a chart of a large Australian company called Spotless a few years back that had suffered a 32.5% overnight drop. A drop that big in the share price of a large company is big in anyone’s language. This sudden move presents a number of lessons that are particularly important because they can cause very large losses if you are not careful as a stock trader.
Looking a bit more closely we see that the share price of Spotless dropped by 32.5% overnight…what happened?
Australian stock released a seemingly innocuous (yet obviously bearish) update to its future trading conditions. This was just a small number of weeks after quite a positive projection and forecast by the company…yet the new announcement caused the share price to almost halve overnight!This raises several questions that are very relevant to all of us stock traders:
- How could the company’s future prospects change so dramatically in just a few short weeks?
- Why was such an unrealistic (in hindsight) projection put out in the first place?
- Was the business not disclosing something that they knew earlier?
- How can we possibly make money in the markets when this sort of thing happens?
Well let me address each of these questions in turn – the last is obviously the most important for us, but the first three are useful context:
1. How could the company’s future prospects change so dramatically in just a few short weeks?
The short answer is that company prospects don’t usually change so dramatically in such a short space of time.In my article on trend trading stocks I talk about market inefficiency, trending fundamentals and investor sentiment and how they drive share price trends.
What the article does not talk about is how if something unexpected happens in the fundamentals (or the management communicates something they didn’t previously communicate) then the investor sentiment can change dramatically overnight.The challenging thing is that if we are in a trade and this happens, there is sometimes no opportunity to get out – just like in the case of Spotless on December 2, 2015 on the Australian Stock Exchange.
So the real company prospects may have changed by a little, or by a lot, but the real key is that investor sentiment changed because of an unexpected announcement – and this caused a massive gap down in the stock price.
It will be interesting to watch this stock over the next few months and see how it plays out, but for me as a technical trader this will only be an exercise in curiosity because I would only ever trade this if I happened to get a signal from my stock trading system.
2. Why was such an unrealistic (in hindsight) projection put out in the first place?
If you have spent any time in finance for a large listed corporation and you will undoubtedly have observed the tussle between the need to meet internal growth / profit targets and what management really think will (realistically) happen.This tussle can be good because it forces the people running the business day-to-day to be creative and really look for opportunities to grow and improve what they are doing…BUT…sometimes it goes too far.There is talk around about companies coming out of private equity into public listing being too optimistic on their forecasts, and there may be some truth to that but it is impossible to know from the outside what really happened and how much to believe everything that is said publicly – there is always a lot of spin in company announcements!
3. Was the business not disclosing something that they knew earlier?
Again it is impossible to know whether the management knew something material that should have been disclosed earlier…perversely though, this is not really the point for us traders.The main consideration for stock traders is how can we make money consistently. What this stock and countless others show us is that we are never the first to hear the real story, so we just need to trade based on what we know, as it becomes available.
For me this means just focusing on price data because news and announcements are unreliable, have other people’s agenda and spin and we are not sure who has heard and acted on the announcement beforehand.
4. How can we possibly make money in the stock market when this sort of thing happens?
Well this is the 64 thousand dollar question! As we all know it is certainly possible to make money in the stock market, however, there are a couple of important lessons from this stock which are worth keeping in mind as we strive to trade ever more profitably:
1. Big price gaps can happen – so make sure each position is small relative to your portfolio. Ensure your trading plan addresses price gaps. Learn more about creating a great trading by opting in to receive my free training video here.
2. Risk less than you think is optimal – the optimal risk in your trading system backtesting may not include the worst situation you will come across in the future, so risk less than you think is ideal. Check out my blog post on this concept here.
3. Sometimes stop losses are not effective – when the market gaps like this, all you can do is get out at the next day’s open. That is just trading…be at peace with the fact this will sometime happen.
4. Tight stop losses may be an illusion – if you have really tight stop losses, then you can lose many times your intended risk if the stock gaps against you. If you have wider stops then these gaps don’t impact you so much.
Tight stops are ok – but be aware the market could blow through them in a big way and size your positions accordingly. Check out my earlier blog post on tight stop losses here.
5. Hesitation is bad – if you got out at the open you would have sold at $1.485 but if you hesitated and held on 2 more days it would have dropped another 16% – Ouch!
6. Big moves can happen to big companies – Spotless has a market capitalisation of over a billion dollars and it dropped 32.5% overnight. Size is not a guarantee of stability!
So what actions and learnings do you take from this chart?Let me know what this means for your trading by commenting on this post below. Writing the lessons that apply to you is a critical part of internalizing those lessons so please do this to help your own trading.
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