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Compute your probable portfolio risk if the market crashes like 1987.  Please read the disclaimer very carefully.

 

1987 CRASH CALCULATOR

The protected versus the un-protected.

Did you ever wonder what will happen to your account if we have another 1987 style crash?

I have made this little model so you can work it out.

 

The model assumes 100% correlation so please choose only stocks and index futures etc that are highly correlated to the main markets. During violent market declines correlation tends to increase.

 

If you have a basket of commodities or Forex you cannot use them in this model as they would not be correlated in the same manner. Hope you understand all this, it is vital that you do.

 

 

 

  • The crash calculator assumed 100% correlation.
  • Only add your stocks and indices to the maths.
  • Do not add commodities or Forex to this calculator.

What if the output number is negative?

This is the scenario when your portfolio is not protected against a large drop of 22% or more. Many traders got completely wiped out on this day and others got very rich with short positions.

What happened in 1987?

The Dow Jones fell 512 points and this was a 22% decline. Most other main indices fell by similar amounts.

A few suicides occurred but in nearly all of those cases, the deceased had suffered a major loss when the market collapsed. Now traders are more crash aware and as a result of those events have learned to have much more diversification in their portfolios and hold a few short positions to ensure against market downturns.

                Price target computer    *NEW* Free calculator

Computing Optimal risk  *NEW* Free calculator

 

How clever are you? Try the Trading IQ game

 

 

Type in your long and short value and your account balance below.

Value of your longs                             (Type in a zero if no longs)  

Value of your shorts                            (Type in a zero if no shorts)  

Margin on your account                      (The cash value on your account)

Your profits in a 1987 move are             

Your account balance would be                 

 

How to protect your portfolio against a violent market crash?

 

Fortunately there are many products and methods available to insure a net long portfolio.

Using derivatives.

Put options are the right to sell at a given price but not an obligation to do so. Holding a few puts which are a long way "out of the money" can greatly reduce risk. You can read more about different option hedging strategies the hedging pages. Think of it like getting your car insured, you can choose from third party, third party fire and theft or fully comprehensive cover. Most traders know that the money spent on insuring with puts will rarely be repaid, but still do it to enable them to sleep easy at night safe in the knowledge that if the crash comes the puts will cover some or all of the losses resulting from holding many long positions.

 

 

Volatility index (VIX and VDAX) Volatility is a mathematical "fear factor" which measures the risk assigned to traded options and is derived from the sellers perception of how much risk is involved by being short of an option. If you buy put options at a strike price of 4000 and the FT-SE100 is at 5500 then they are a long way "out of the money" and are very unlikely to expire with an intrinsic value. ( below 4000 ) The process of buying these involves a seller, as someone must sell them to you in order for you to buy them. This person is known as an "option writer" and when the market is rising gently the cost of these options will be very low, but if the market is making violent swings the price will be much higher. This is due to the volatility element of the Black Scholes formula. If the market takes a dive the option writer is carrying a huge risk as the cost of the puts may have been just a few pence when he sold them to you but could rise to hundreds of pence if the market dips close to or below 4000.

The cut a long story short, the VIX index is now tradable as a futures contract and avoids the slow trickle loss that one gets from time decay as a result of buying puts or calls. Buying the VIX is a hedge against rising volatility which goes hand in hand with market dives.

ETFs  (Exchange traded funds) There are many ETFs available which have become popular as they allow regular traders to participate in products which were only previously available to futures traders.  ETFs can be bought which are short positions in reverse such as ShortDow30 or UltraShort Midcap 400, some of these are geared 2 or 3 times. These are available for all major markets and commodities and cannot be shorted, the short "effect" is gained by buying a long position in a short ETF.

 

Other methods of protection against crashes.

Holding short positions ( For disciplined traders who understand the risks )

As you have seen from the calculator above, the presence of a few short positions which profit from a market collapse greatly reduces the risk of wiping out your account. On a negative note, short selling can lead to complete disaster if a trader lacks the discipline to cut a loss when the price rises. I have heard some incredible stories of people losing their homes and wiping out their accounts by holding shorts way too long. Being short carries unlimited loss potential, as there is no upper limit for prices. On a more positive note however, a responsible risk averse trader will know how to handle short positions with care and use them to his advantage. In a raging bull market shorts can be hard to find, but the determined workaholic trader will manage to find those stocks which are weak. Profiting from long trades AND short trades is the authors preferred style.

Stop orders to open new short positions

This method is the cheapest way, as its is completely free to place an order. E.G If the trader has a long portfolio of mostly large cap US stocks then he can hedge his risk by leaving a stop order to sell the SP500 futures at a level some distance below the current market price. This method in itself is not full protection.

Whilst it would seem solid enough and in most cases it would be, but if the weekend produced some shock news the market would likely gap many points lower on Monday morning and your entry price could be way below your original stop order. Using a 24 hour futures market to hedge is obviously more favourable than to place a stop order on a few similar stocks to those held as the gap down on the open problem is reduced.  This method is like third party cover, and would suffice most of the time, but its not going to help you if there is a black weekend.

 

 

Stop loss orders on your actual trades.

This is obviously a must have element of risk control as your individual trades could crash on bad news without the whole market being affected, but as the above scenario shows, its not full crash protection for the same reasons.

Trade smaller with less gearing

As humans we all usually have the same basic greed in our nature, and most traders do not fully understand the risks involved in holding huge geared positions as they feel like bigshots when using tiny margins to support their massive trades. Some of us are aware of the dangers and do not trade at gearing levels that can lead to catastrophe. You have been warned.

Trading idiots often make the below type of comments.

  • This market is very safe, no way its going to crash
  • If the market crashes then all people will lose too so it doesn't matter
  • It wasn't my fault that I lost all my money, the market crashed and nobody expected it

If you wipe out your account, its your fault and nobody else.

LTCM blamed the Russian debt default for their catastrophic wipe out after foolishly computing an upper limit to the volatility of the options they had sold. Once the volatility rose to their maximum upper limit, they added further written options to an already losing portfolio. After Boris Yeltzin announced that Russia would not pay its debt, the option volatility rose to levels some 50% above their expectations....

My research has revealed with 100% accuracy that the upper limit for a price to achieve is infinity, and the lower limit is zero.

Believing anything else can seriously damage your wealth.  Try the following pages if you are skeptical.

 

How to use traded options for hedging

Price target computer    *NEW* Free calculator

 

Computing Optimal risk  *NEW* Free calculator

 

 

                                                                                          Disclaimer please read carefully
 

All the indicators, functions, signals and formulas available from PrecisionTradingSystems have been selected for their high levels of efficiency as trading tools.

However this does not guarantee success when using them on all markets you choose to trade in.

Risk of losses are high with even the best systems, and a good understanding of risk control mechanics is required before using any products you have received from PrecisionTradingSystems.

You are responsible for ensuring all precautions have been taken in your trading decisions and PrecisionTradingSystems cannot be help responsible for any losses you may incur while using its products.

These products and formulas are designed for Traders who have several years experience of trading, if you do not consider yourself in this category then please invest some time to study your methods carefully before risking any money.

 

 

 

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