Strategies to Protect You Against Another Downside Move

The real test in the markets will show itself over the next several days or weeks. After the market drubbing on Tuesday that saw the DOW fall by as much as 550 points and the Shanghai Composite Index give up close to 9%, we will watch to see if the markets can hold as they are now technically oversold in the near term.

As I said, I was not surprised to see the selloff, as the current uptrend in place since mid-July 2006 had yet to see a correction of any significant degree. The topping action had been evident as reflected by some chart resistance and technically overbought conditions. Markets were vulnerable to any major negative market shock. The selling in China gave investors here a reason to exit long positions.

The correction was necessary. In the upcoming sessions, watch to see if stocks rebound or trend lower. I expect volatile trading as the bulls and bears battle it out.

In the meantime, there are several things you can do.

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I have always been a big believer in taking some profits off the table especially when gains have been significant. I continue to believe in taking some profits on a portion of a position as the stock trends higher. In doing so, you would lock in some profits and make your position less vulnerable to a selloff like the one we just saw.

Another strategy would be to make sure you have stop-loss orders in place to protect against a downside move. As each stock rises, move the stop-loss higher. I advise setting actual physical stop-loss orders rather than mental stops, as it removes any unwanted emotion in the trading process.

A third strategy would be to buy put options on a stock if you have a major position or put options on an index that reflects the composition of your portfolio. Put options will help to minimize a downward move in the stock or market.