The Dow, May 6, 2010: 5 Lessons from the 1,000 Point Plunge

The finger pointing is in full swing, and it may take some time to sort things out but what really matters is not what the market did but how you reacted. Did you panic and push the sell button when the Dow was down 1,000 points, only to regret it five minutes later? Did you buy a short ETF at the top of the spike and are now wondering whether you will be able to recoup the almost instant loss? Did you put in a market order that filled at a ridiculous price? Or did you stay cool and watch the panic dispassionately? Or, better yet, did you profit by selling your short position into the spike? These are the fundamental questions, as times like this define you as a trader.

Whether or not some trades will be busted remains to be seen but one thing is certain: even if the culprit is human error, it did not occur out of the blue on a tranquil sunny day. Fear and panic had been building before the plunge. Even if the worst is purged from the record, we will still have a pretty nasty day.

The Dow opened at 10,862 and took 1 hour 40 min. to lose the first 100 pints. It lost the last 600 points in just 10 minutes on humongous volume, before recovering 700 points into the close. The dynamic reveals a lot about human nature:

Lesson 1: People act on their most recent memories first.

Remember the Internet meltdown of 2000 - 2001? As bad as it got, leading stocks took months to reach bottom, with institutions and pundits raving about "historic buying opportunities" all the way. People learned that you can get burned pretty badly if you don't get out fast. So in 2008 people acted much faster. Still, it got pretty bad. So this time everyone wanted out at the same time. The result? A 1,000 point plunge and a 700 point recovery, all in one day.

Lesson 2: When you see a huge drop on huge volume, a bottom is near. If you haven't sold early, you may hurt yourself more than help by selling in a panic.

Bottoms are reached when all who wanted to sell have done so, and there are no more sellers left. If selling is gradual, the declining prices bring out more sellers as frustrated bulls throw in the towel one by one. If everyone wants out at the same time, prices drop instantaneously. Most people have similar pain thresholds. When those are reached, they panic and sell. Again, the majority will get there more or less at the same time. That's why bottoms usually occur on the highest volume.

Lesson 3: The most important feature in an online brokerage account is not low commissions or bells and whistles but how robust the system is.

Did your trading platform freeze and your broker's phone line have a 30 minute wait?

Lesson 4: Theoretical or historical knowledge is of little value in trading if you can't put it to timely use.

We all know the theory: buy when blood is running in the streets. But did you put it into practice today or did you freeze in disbelief?

And lastly:

Lesson 5: A key ingredient in successful trading is emotion control.

Emotional decisions usually don't pan out. How did you feel? Regardless of what you did, did you manage to stay calm and impassionate? Because days like this don't happen often but they are bound to happen again, and it pays to be prepared.