How to Navigate the Next Market Malfunction

NEW YORK ( TheStreet) -- The big story Thursday was the halt in trading on the Nasdaq stock market, an event that already has been dubbed the "Flash Freeze."

For now, Nasdaq OMX ( NDAQ), which runs the exchange, is blaming the shutdown on a problem with the Securities Information Processor, the system that collects and disseminates the price quotes that drive trading.

This is a developing story, and we don't know all the details yet. Although the exact cause for yesterday's outage remains uncertain, one thing is certain: There will be more glitches in the future.

That means individual investors should gird themselves for the next one.

Yesterday, on CNBC, just about every segment included a question about how investors should trade around the halt.

Although there was a wide range of responses, the best thing for the average investor to do is to avoid trading around -- and during -- a market outage.

That's because a shutdown or other technical glitch on an exchange could leave an investor stuck in an "erroneous" trade that is forced to stand.

In the 1990s I worked at Charles Schwab ( SCHW) in an area called trade support that fixed trading problems.

This was back in the early days of online trading, and the company Web site used to go down all the time. Even though we warned customers that they might not know for hours whether their orders were placed or at what price, many customers still went ahead and placed them.

So an investor could have found herself in the position of having submitted a buy order early in the day without receiving a trade confirmation. Then the stock price could have slumped 10% from when she placed her original order, but she wouldn't know whether her order was filled, or whether it was filled at her intended price or at the cheaper price. Wouldn't you want to avoid being in that position?

This might seem silly now, but our trade support department spent hours discussing such situations on days our Web site crashed.

On May 6th, 2010, the day of the Flash Crash, someone sold Procter & Gamble ( PG) for less than $40 even though shares opened for trading that day at more than $60 and closed the session at more than $60.

Companies do not lose one-third of their value over the course of 15 or 20 minutes on no news. Baskets of stocks under the hood of an ETF do not go from a net asset value of $55 to 15 cents in a matter of minutes as many ETFs did during the Flash Crash, including the Vanguard Telecommunication Services ETF ( VOX).

This seems obvious in hindsight, but on that day there was plenty of confusion and plenty of panic sales, some of which were allowed to be canceled, but not orders for PG at $40.

Early on during the Flash Freeze Thursday there were reports that investors would be let out of any orders that they had entered. Not surprisingly, that announcement was replaced by a warning to investors that they would need to cancel their orders if they did not want to participate in the reopen.

Leaving an order in Thursday likely would have left investors stuck with trade executions they wouldn't have wanted.

There was no reason an investor couldn't have canceled any open orders, waited for an orderly reopen, and then placed fresh trades.

In these events, there's also the potential that you can be thrown off your game by seeing a value in your account that is a fraction of what it should be.

Again, stocks and funds do not lose one-quarter or one-third of their value suddenly on no news. People who trade in the face of these technical glitches and outages risk being stuck with the equivalent of having sold PG at $40 on the day of the Flash Crash.

These events are going to come along every now and then. It bears repeating that in the face of a market-wide malfunction, the best course of action is to recognize it for what it is and simply step away.

At the time of publication, Nusbaum had no positions in securities mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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