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How to optimize a stop-loss strategy with ETFs

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Monday, Aug. 24, 2015.

It was a chaotic day in the markets, with the Dow Jones Industrial Average, S&P 500 and Nasdaq Composite all cratering shortly after the open.

U.S. futures sell orders had started building before the market opened. Some listed securities had so many sellers that prices fell precipitously, which triggered limit-up and limit-down halts, causing tremendous confusion and delay.

But market participants would have had a much less stressful time if they had in place stop-loss orders.

A stop-loss strategy with an exchange-traded fund is a simple, efficient approach that can protect against dramatic downturns associated with rocky economies and the market.

Also, stop-loss with capital preservation as the driving force allows investors to capitalize on the majority of upside trends to meet long-term financial goals, while protecting against severe downturns.

Simply put, a stop-loss order is placed with a brokerage firm to buy or sell once the stock price hits a certain price. A stop-loss is designed to limit an investor’s loss on a security position, hence its name.

When trading ETFs through a brokerage account, investors can choose among various order types, such as a market order or a limit order, said Tom Lydon, editor of ETFtrends.com and president of New York-based Global Trends Investments in Irvine, Calif., a registered investment advisor.

“The options also apply to stop-loss trades that trigger an automatic sell order when an ETF dips to a certain point,” he said.

At that point, “stop-loss orders are converted over to market orders to sell at the next available price,” Lydon said.

A limit order is designed to fill at a specific price or better, he said.

A buy order would purchase the ETF at or below a stated price, while a sell order will only be triggered at the stated limit price or higher.

One key advantage of an ETF stop-loss strategy is it “allows investors to be free from any emotional influences,” said Chris Cook, an advisor and president of Dayton, Ohio-based Beacon Capital Management, a portfolio management firm with $2 billion in assets under management. “Advisors get fewer calls from nervous clients when a stop-loss strategy is utilized.”

The disadvantage is that the stop price could be activated by a short-term fluctuation, Cook said.

An extreme recent example is the market collapse of 2008.

Cook takes a pre-emptive approach “to protect positions from market corrections as well as our clients’ often emotion-driven decisions, which tend to start around the 10% mark,” he said.

Cook likens the stop-loss strategy to minimizing the turbulence on an airplane ride.

“We want a nice smooth flight. Normally, when a plane hits an air pocket and suddenly drops 100 feet people can get hurt,” Cook said.

A stop-loss “is the seat belt that holds the passengers in and protects them from serious harm,” he said.

Bruce W. Fraser, a New York financial writer, contributes to Financial Planning and On Wall Street.

This story is part of a 30-30 series on smart ETF strategies.

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