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Learning to avoid a stock market crash comes from learning how to play superior defense. You always have to be able to define where the risk is and where your blind spots are.

If you have money committed in the market – as a trader or investor – you must be able to define your risk. If you don’t know these specific points, you’re likely to suffer both a financial and emotional shock to your system.

It’s hard enough to make money in the market. When it gives you a gift, like it’s done the past several years, you have to protect your equity like it’s a new born child. You don’t give it back or let it get taken away.

Let me know what you think in the comments or on Twitter, and please send this to anyone who you think has confused brains with a bull market. They will thank you for it.

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You need to have a plan in place BEFORE the correction occurs. Let the amateurs do all the rubber-necking while you confidently wait for the scenario to play out as you anticipated. Once the HFTs pile in, you’ll be in the right place at the right time.

Learn From the Mistakes I Made Early in My Career

However you decide to position yourself, have your exit strategy planned out as well. If you read my book, you know that I mishandled exiting the monster INTC Call position that I had. I still made great gains, but it could have been several MULTIPLES more.

Have a Contingency Trading Plan for Multiple Outcomes

When a correction hits, it catches most people by surprise. This is a negative Black Swan. You, however, can be prepared by writing out several potential scenarios when it hits by using history as a guide.

All you have to do then is execute. Mozart’s compositions are said to be flawlessly written with no mistakes. He simply transcribed the music that was already written in his head. You can do the same with your trading.

1. What will you do if the S&P 500 opens Limit Down?
2. What will you do if Limits are expanded and you see further substantial weakness?
3. How will you protect your capital in the other positions in your portfolio (from Floor Creep, for example)?
4. What is your low-risk method to trade a snap-back upswing?

If you watch the video, you need to come up with a macro plan first. Once you do, the technical part of entering the trade is easy.

Here is some recent feedback from the market from widely followed money managers that has come out since the video was recorded.

Marc Faber: We are in a massive speculative bubble

Howard Marks: Heed this Omen: The risks of 2007 are back

Jim Cramer: learn to develop a Macro view in his new book Get Rich Carefully

Please consider sending this to anyone who you think will benefit from it.

Students of my Trader Coaching and Mentoring program are busy watching the follow up video on how to put on the trades.

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Check out this great article from Open Markets / CME Group. It underscores the important role that speculators and traders play in the overall business of agriculture. Without being able to lay off the risk, farmers would have a tough time calculating profitability. That in turns effects how much they can borrow from the bank.

“He can look at the hedging strategy and see what the farmer’s profit potential is before the trade is executed. “I know if they’re spending $30,000 in margin money, they may be protecting a profit potential of $150,000,” he says. “It’s easier to explain (to the bank’s approving committee) that margin money, which had that label of being money you throw out the window, now its protecting a risk management plan.”

“It’s one more tool that I can use to verify that the money I’m being asked for is being used for a risk management plan, not a speculative plan.”

Right. Who’s taking the other side of the trade?

Read the full article at Open Markets.

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Steve Sears led a dynamic discussion on the use of options in a portfolio. I spoke with him briefly after his presentation about some of the points that he made during the conference.

Steve writes the Striking Price column for Barron’s each week and is the author of The Indomitable Investor: Why a Few Succeed in the Stock Market When Everyone Else Fails.

You can listen to the podcast that I recorded with Steve in April 2012 when his book was released.

Follow Steve on Twitter.

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Sal Arnuk is an partner at Themis Trading, an institutional brokerage firm. He’s also the co-author of Broken Markets: How High Frequency Trading and Predatory Practices on Wall Street are Destroying Investor Confidence and Your Portfolio.

We spoke about liquidity in the markets and the business of trading.

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