Stock market meltdowns, a time when fortunes are made and lost on markets around the world. At such times rational analysis, logic and computer keyboards go out the window. “Surely the market can’t go any lower.” “It just has mate.” And, like earthquakes and West Ham victories, they occur a lot more than you think they do. But a cool head and a list of do’s and don’ts can help you to profit from, rather than fear, such events.

Since I’ve been Spreadbetting the market had seriously dumped on 5 occasions; May 06 10%, Feb/March 07 7%, July/August 07 14%, November 07 10%, but January 08 was by far the biggest with a head to toe collapse of around 18%. It wasn’t just the percentage drop, but the scrotum-tightening rapidity of the fall that characterised the market meltdown.

What Melts And Why?
This isn’t just your normal market sell-off; traders having the arse because inflation’s too high or Marks & Sparks didn’t sell enough knickers at Christmas. Meltdown is when the markets are hit by wave after wave of indiscriminate selling. Most investors aren’t sure why they’re selling, except that they’re watching prices collapse; some are even at the mercy of clever computers that do it automatically. And the word ‘contagion’ crops up a lot. Contagion is the effect of a sharp fall in the prices of one financial market knocking back the prices in other financial markets. One of the best-documented examples of contagion is ‘Black Monday’ on October 19th 1987. Falling share prices in Hong Kong followed daylight hours and triggered a drop in Europe, which then moved on to cause heavy damage in the US. Once people saw the damage done in the US a second day of falling prices hit Asia, then Europe, and caused more selling in the US morning session before prices steadied in the afternoon. If you found that interesting and crave just a little bit more about the whole bubble thingy,why not have a butchers at Z’s excellent piece Will It Burst,Won’t it Burst.

Not For Beginners
First off, a bit of a health warning, if you’re new to trading, and I’m not trying to sound like your gran here, think twice about jumping in. The land of opportunities is strewn with quicksand that will suck you in, twist you around and spit you out a quivering, poorer wreck (been there, done that). Why not make use of the demo account to feel your way in these markets, trying out your techniques, watching how quickly the P/L moves and seeing how the stomach copes with it.

If that hasn’t put you off then here we go:

The trend definitely is your best mate
This is not a time for trying to be clever and seeking undervalued stocks, sectors that look safer or calling the turn in markets. The herd mentality, and clichés about falling knives, dominates. This is no time for heroics or individualism, embrace the safety of the crowd. And don’t be tempted to trade a volatile market if you can’t recognise a trend. Accept that we’re at the back of the queue for information flows, so we’ll always be chasing some-one else’s tail.

Make like The Japanese
No, I don’t recommend a diet of raw whale, or collective yoga before work; I mean think small. Trading these markets means setting a much wider stop loss to avoid the sudden, sharp corrections. And, if you remember your risk management (Be Safe Be Sure And Always Use One Of These), in order to keep your risk exposure at the same percentage you need to reduce your bet size. Selling in £25 can put a bulge in your pants when the market’s plunging, but a sudden change of direction will have the effect of skinny-dipping in February.

Forget The Dark Arts
What, me dissing technical analysis? On this occasion yes, apart from the most simple one-the trend line. I still look at key levels, but I use them as a warning of when not to sell, rather than to call a turn in the market. Quite often there’s an underlying reason for the selling (the media just try and pin it on something glib like ‘fears of a recession’ because they don’t know any better), which only becomes public days after the event. And usually the underlying reason doesn’t give a monkey’s tits if there’s a bullish signal caused by three magpies flying over two mating toads. For example, in March 2007 the Dow fell by 178 points in a minute. It was only revealed the following day that this was due to a computer glitch in pricing the index, but by that time fortunes had been made and lost.

See A Shrink
If you’re not right in the head don’t deal. I’m not talking about those little voices telling you that you’re Spiderman’s love child, or having a strange inclination to support Chelsea. I mean if you’re nursing losses, or you’ve just been turned over on your last few trades, don’t jump into the market. I’ve closed out potentially winning trades before because without the self-belief I didn’t have the confidence to ride out the losses and keep backing my judgement.

Mind The Gap
Meltdowns don’t provide smooth continuous markets, they’re noisy, erratic and bits in the middle suddenly go missing. There can be massive price differences (gaps) between the market close and the following morning’s opening price, reflecting changes in US and Asian markets whilst we were watching Celebrity Cooks on Skates or, preferably, sleeping. But the markets can also gap during normal hours in reaction to some news or event, such as a surprise change in interest rates. The important point here is that your stop loss isn’t guaranteed and the risk is that the trade gets closed out at the next available price, which could be a country mile away.

A Profit’s Good, But Keep Your Shirt
I prefer actively trading this sort of market; to be honest I enjoy the buzz. I reckon that on the right day you can get a real feel for it, judging when to add to a position, when to take profits and the point to re-open the trade, it’s almost as good as sex. A common mistake is to feel that as the trading’s going swimmingly, why not repeat the move with some proper wedge. Beware! Sod’s Law is lurking round the corner waiting for you to do just that. That’s when the market will immediately go against your trade; it probably did the time before, but you were relaxed when it was only in a fiver, but now that loss is multiplying like Polish plumbers in Slough. It doesn’t take long to wipe out your earlier gains and rip the shirt off your back.

Don’t worry if you’ve just missed this meltdown, print the article and stick it by your computer, there’ll be another one along soon. Sorry, what are the warning signs? Well, usually there’s a bubble waiting to burst, we’re all aware of it but tire of nothing happening then there’s a catalyst ( a storm, a rogue trader, or a dodgy computer) and all hell’s let loose.