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When Disaster Strikes…

Holding trades overnight has certain benefits and risks. We consider it a necessary part of a trading plan to have a "Wealth Building Account" for swing and core trades, which would all be overnight holds. So following your trading plan and playing the proper share size are very important. Properly handled, over time the benefits should outweigh the risks. However, no matter how careful you are, you will have a morning where a position you have is gapping open against you.

Remember, overnight there are no stops. Let us say you are long XYZ at $30.00, and at 7:00 a.m. EST the next morning company XYZ makes some announcements. Let us say they are going to miss their next earnings number, and that the CEO just resigned, and that they suspect they have accounting problems. There is a good chance (about 99.99%) that when trading starts the next morning at 8:00 a.m. EST (pre-market trading starts with ECNs at this time) that your stock will be trading much lower. Let's say at 8:00 it starts trading at $26.00. From 8:00-9:30 it ranges from $26.00 - $25.00. Then at 9:00 it opens at 25.10. It will not matter that you have a stop in place at $28.50. During pre-market, stops are not in effect. Then when the market opens, your stop will be filled (if it is GTC, or if you re-entered it at open) at the best price at the time, $25.10, not your desired price of $28.50.

So, how do you handle these 'disaster' situations? Here are some tips to put the odds in your favor to manage these situations in the best way over the long term:

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First, do not panic. Easy to say, but hard to do. However, it will not be hard to do if you have a strategy in place out for these situations.

Second, ignore the pre-market trading. From 8:00 until 9:30 only ECNs are trading; some stocks don't trade at all. If your stock is gapping down like this, it will likely be trading, but will likely be trading erratically.

Third, when it opens officially at 9:30 EST, do nothing for five minutes. That is right, just watch it. After five minutes, mark off the low and put a stop for half your shares $.05-.10 under that five-minute low.

Fourth, let it trade for 30 minutes. Then put a stop for the other half of your shares $.05-.10 under that 30-minute low. At this point, if the stock did not violate the five-minute low, you will still have all your shares, half with a stop under the five-minute low, half under the 30-minute low.

You will find on many occasions, that you may still have all your shares, or at least half. Often, after a large gap, the opening half hour puts in the lows for the upcoming days. If your shares do stop, you are usually risking a relatively small amount extra.

From there, you can treat the trade as a swing with a one-day trailing stop, or the stock may rebound to prior levels and you can follow your prior plan. While the example given was for a gap down on a long position, the exact same rules hold true for gapping up on a short position. Use 5- and 30-minute highs as stops.

Having this as your plan for disaster will help you minimize the losses over the long term.

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