Have a Drill for Market Disasters

Got burned Wednesday? Use these tips to be sure you don't get caught next time.
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This column was originally published on RealMoney on Jan. 19 at 11:30 a.m. EST. It's being republished as a bonus for TheStreet.com readers.

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)

ahead of

Yahoo!'s

(YHOO)

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.

Strategies

Jumping ship early can save your account from damage, but it's not always the best thing to do. Studies indicate that the majority of gap-downs print the low of the day within the first 15 minutes of the session. This is vital information when a position opens well below your intended exit.

In many cases, the best course of action is to stand aside and place a stop-loss under the low of the first 30 minutes of the trading day. Then, if it doesn't get hit in the morning session, look to sell the position on the first rally into the gap or the closing bell, whichever comes first.

Consider the value of hedging when good trades go bad. It makes sense to keep a few exchange-traded funds in front of your nose at all times. ETFs are not subject to the uptick rule, and can be used as hedges against positions that can't be exited at rational prices. Of course, put or call options will also mitigate losses, but they may not be available when news hits the market before or after regular trading hours.

Use the preopen and postclose markets to take safe exits whenever possible. Consider the advantage you'll have when other traders sleep in and miss the predawn session that takes place before the opening bell. Of course, in order to do this, you need a broker that lets you trade actively during this period.

Most market-moving news is released before or after regular trading hours. That timing will let you take advantage of delayed reactions and run for cover while other shareholders are brushing their teeth or making the commute home. In any case, you need to be at your desk when the news is released so you can act instantly, when required.

Sift Through the Rubble

After the dust settles, go back and analyze your losses during these volatile sessions. They inevitably reveal structural flaws in your approach to the market. And if the drawdowns are triggering major depression or other emotional conditions, your positions are way too big for your risk tolerance.

Accepting the reality of event risk in advance reduces its shock value when it does happen, and helps you mitigate its impact to your bottom line. Whatever you do, don't panic and dump your positions at the worst possible prices.

The best way to prepare for disaster is constant role-playing and visualization. See it happening in your head and in the way you currently manage your open positions. Then you'll act without hesitation when the real thing comes along.

A rapid response to critical events can mean the difference between a bad day and a major catastrophe. Become a deer in the headlights when disaster strikes, and it's bye-bye Bambi.

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;

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