Thursday, ADVO Inc (AD) shares were down 25%. Every day, there are price shocks like this, and we've all experienced them. Sometimes, the shocks help us, and other times they do not. The real question is, "How should we deal with these shocks?" Today, we will discuss price shocks. Specifically, we will look at whether they are predictable, how to act when they occur and how to factor price shocks appropriately into systems testing.

Predicting the Future

The most important concept to remember regarding price shocks is that they ARE NOT predictable (unless you have inside information). You take ADVO's move today for example. There is nothing on the chart that suggested that merger partner Valassis would pull out and sue ADVO. The first thing that must be realized is that price shocks cannot be predicted. The difference between price shocks and average trends is that average trends tend to have recurring, gradual patterns, whereas price shocks tend to occur suddenly with no recurring patterns preceding the shocks. Generally speaking, half of price shocks will move in your favor and the other half will not. Now, let's move on to price shocks and their affects on system testing. Systems testers need to be aware of the effects of price shocks on their data. The most common mistakes that systems testers make are:

• Testing during periods that had not significant shocks
• Erroneously selecting strategies with the highest net profit due to price shocks
• Just getting lucky enough to be out of the market during a shock.

This is why it's important to look at charts when testing and optimizing. Your results could potentially betray you if you don't' including the right data. You should realize that when testing, it's possible to tweak your rules so that they are always on the right side of a price shock. That's because you have a small data set and you could potentially be over fitting your optimal levels and strategies in ways that fit ONLY THE PAST. The point is, keep an eye on your charts when you are evaluating a new system. Make sure the system didn't just get lucky in the short-term. You can avoid this by, using several test periods of at least 2-3 years a piece.

What to Do

Let's now discuss actions steps when a price shock does occur. First of all, what should you do if a price shock moves against you? If the price shock crosses below your stop loss, then get out of the position. If you are not crossing a stop, then hold the position for one day after the shock. You can now exit if the price closes at another extreme price point, or if you get a contrarian trend signal. In the case that you price shock is favorable, it is usually best to exit at close or open the next day. The reason is that volatility is usually high immediately after a price shock and the trading system that you usually use is no longer valid. It's better to move on with your normal system at that point. Keep these points in mind when evaluating systems and after encountering price shocks. 

Price Headley is the founder and chief analyst of BigTrends.com.