Riding the Falling Knife

Everyone is familiar with the old warning about not trying to catch a falling knife, but what if you’re already holding the dull end of that knife?

Let’s say the market is down 30% from recent highs and you’ve been short most of the way down. The prior day was a 5% down day on less than impressive volume, and today is already looking just as ugly. You’re making money hand over fist, and another big down day could add 15% in a day if you’re leveraged. Jack Schwager is bound to be emailing about his next book soon. What do you do?

Get out. Now.

Especially in the current climate, the conditions described are the perfect fuel for large, unpredictable, ham-fisted interventions. Banning short selling, closing markets, direct Fed purchases of whatever they feel like, even banning selling altogether has been tried in some countries (though it didn’t work either). Even without outside interventions, volatility cuts both ways. When the daily range gets too large in a one-way trade it’s a virtual certainty it will soon be equally large in the opposite direction, vaporizing your profits as quickly as they appeared.

It isn’t easy to abandon your fantasies when a short trade is wildly exceeding expectations. Getting out early will often leave money on the table, sometimes a lot of money, which can be very hard to tolerate. But consider how it would feel being stuck in a short while the exchanges and government engineer the biggest rally in human history before reopening the market, or if the market leaps over your stops and keeps on going, vaporizing your paper profits with the fill from hell.

Climactic declines happen the way they do because there really aren’t that many people willing to try catching falling knives. When they happen it can be a great time to be short, but don’t let greed blind you to the danger of trying to ride that falling knife all the way to the ground.

* For the bulls feeling ignored by this post, turn your tablet upside down while you read and think of Apple’s recent parabolic rise.

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