Yield impulsive stop-loss orders

Written by Gary Silverman, CFP®

Exchange Traded Funds (ETFs) are the darlings of the investment world these days. They consist of baskets of (usually) indexed securities that have expenses lower than equivalent mutual funds  that can be traded throughout the day and that don’t typically sell at any premium or discounts to the underlying securities. Folks love them even if they don’t understand them. Although it would take several columns to explain just how they work, people continue to invest in them. They now hold over $2 trillion in assets.

Well, ETFs showed a weak spot a few months ago when several traded at severe discounts to their true worth. For instance, one that I’ve used effectively in the past, the Guggenheim Equal Weight S&P 500 ETF (ticker:RSP) dropped to a price that was 30% lower than what its component parts were worth.

Most people probably didn’t care. After all, unless you happened to be selling at just the wrong time on just the wrong day you wouldn’t notice. Yet some people did trade, quite willingly, as they saw the price plunge, panicked, and thought the sky was falling. But a lot of people panicked without even noticing the price drop. How? Through stop loss orders.

Quite a few people try to protect their potential losses by putting stop loss market orders on their holdings. This means you choose the lowest price you feel you could tolerate and if your holding dropped to or below that number, a sell order would be immediately generated. In theory, this keeps you from losing your shirt if the market plummets when you aren’t looking. I’ve never been much of a proponent of these and you’ll see why in a moment.

Imagine if you bought RSP at $60 and it was now worth $70/share. You think to yourself, “Self, I think this will still go up, so I don’t want to sell it, but just in case, I’m going to protect the downside.” You then call your broker and put a stop loss at 10% below, or $63/share.

Now, the “flash crash” as the little incident is now called, occurred. At the market open your holding that was worth $70 at the close of business the night before starts trading at $50. Math says that $50 is lower than $63 and a sell order is automatically generated on the shares you own. They sell at or around $50. But this was a momentary fluke. Eventually things sort themselves out and the price goes back above $70 a share.

I don’t know how you’d feel, but “happy” is probably not the adjective you’d use.

Lessons learned:

One—if you are going to invest in something, like an ETF, learn how they work.

Two—if you are going to use a strategy like stop loss orders, learn how they work.

Three—if you are going to use a strategy like stop loss orders on an investment like ETFs, don’t just think about what happens if everything goes right, think what might happen if things go wrong.

This article was published in Wichita Falls Times Record News on November 1, 2015.