Have a Drill for Market Disasters

Did Wednesday's selloff expose a serious flaw in your trading strategy? It sure did if you woke up without an escape plan to deal with the gut-wrenching decline. And your capital will stay at risk until you put together a fire drill to get out of positions when disaster strikes.

Electronic trading can trigger violent price moves at any time. And carefully placed stops won't help you, as many folks discovered on Wednesday morning. Major gaps down will cut through stop-loss orders, filling positions well below intended exit prices.

Of course, that doesn't mean we should throw our stop-loss strategies out the window. But shock events require a thoughtful response to protect capital and manage downside risk. It starts with early recognition of the danger and immediate action.

Click With an Example

Perhaps you buy a strong stock like Internet ad media provider ValueClick (VCLK - commentary - Cramer's Take) ahead of Yahoo!'s (YHOO - commentary - Cramer's Take) earnings, hoping to benefit from a sector rally. You're sitting on a small profit and feeling good about your decision making. But things can change in a hurry.

Suddenly your position gets caught in the Internet selloff on Tuesday evening. While Yahoo! falls more than 5 points within minutes of its earnings release, your stock takes almost an hour to drop into its post-market low. Did you realize this was a window of opportunity to dump the position at a more advantageous price?

Premarket trading on Wednesday morning also offered a range of pricing you could have used to get out of this hypothetical position completely, or at least to mitigate the loss through partial sales. And look what happened if you waited until the market opened Wednesday morning.

Many shareholders can't access the preopen or postclose markets. These emotional sellers put out waves of opening market orders that get abused by insiders. The result on ValueClick: sharp volatility in the opening minutes and exit prices that ensure major losses.

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Alan Farley is a professional trader and author of The Master Swing Trader. Farley also runs a Web site called HardRightEdge.com, an online resource for trading education, technical analysis and short-term investment strategies. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Farley appreciates your feedback; click here to send him an email. Also, click here to sign up for Farley's premium subscription product The Daily Swing Trade brought to you exclusively by TheStreet.com.

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