ETF Talk: Stop Losses and Avoiding Freefalls

You and probably every other investor in the world right now are concerned about avoiding big losses in the equity markets. It certainly is understandable, in light of the big pullbacks in markets virtually across the globe.

But did you know that there is an easy way to limit your downside in equity investments? I have applied this technique successfully many times this year with exchange-traded funds (ETFs).

The safeguard that I use is to set stop losses.

This can be done as easily with individual stocks as with equity ETFs. Sure, everybody wants to profit, but you need to be prepared for when your investments go south. If you invest, this is going to happen to you. Hey, it’s part of the game, but losses don’t have to keep you out of the game. If you plan accordingly, you can cut your losses and/or protect gains by setting stop losses.

Now, because ETFs tend to be less volatile than individual equities, you may not feel the need to set a stop loss. This, in my view, is a big mistake. No matter how great your risk tolerance may be, you should always set a stop loss on every ETF you buy. Your stop loss could be 15% below your original buy price or 10% if you are more conservative. You also could be really conservative and set a stop loss below 10%. Just remember that wherever you set your stop loss, don’t be mad if and when your ETF gets sold out from underneath you.

This is not a disaster for your portfolio, but rather disaster avoidance. Think of it this way. You may have saved yourself from a frightening freefall of the sort we’ve seen in many ETFs throughout much of this bear market.

I have been stopped out of positions in the past, then re-entered later and ultimately made money. In fact, I did so recently in my ETF Trader service. If you want to profit from the current market fluctuations, and if you have a strong tolerance for volatility, then check out my ETF Trader service. To do so, click here.

For newcomers to setting stop losses, here’s a brief explanation. A stop-loss order can be placed with your broker or an online brokerage to limit your potential losses in an ETF. You can set the stop loss at the same time that you place your purchase order or you can do so whenever you or your financial advisor feel the timing is right.

A big advantage of a stop loss is that you do not need to monitor your position on a daily basis. You can go on a vacation, enjoy the holiday season or be away from the news for any reason of your choosing, yet still protect yourself from deep losses.

One additional factor to consider is that once the stop price is reached, a stop-loss order becomes a market order. Just because you set a stop loss at $25 does not mean that a buyer is offering that price. In a fast-moving market, the next highest bidder for your shares in an ETF might offer a price of $24.75 or even less, for example. Once your stop order becomes a market order, you receive the best price for that holding currently available. However, do not let this uncertainty deter you from setting stop losses.

Remember, if you have any questions about how to set stop losses for ETFs, feel free to let me know. To e-mail me any questions that you have about ETFs, click here (insert e-mail link). I’ll be happy to answer your questions in a future ETF Talk.