November 11, 2013

Minimize ETF Losses by Fine-Tuning TSOs

In last week’s blog we discussed some of the reasons why it may be beneficial to use ETFs instead of mutual funds. We also discussed the added flexibility ETFs offer in terms of buying and selling. We concluded with a brief mention of trailing stop orders, which cannot be utilized with mutual funds. In this post, we’ll dig deeper into using TSOs in conjunction with ETFs and the protection they offer.

Trailing Stop Orders

Trailing stop orders are essentially a stop order that rises with (i.e., trails) the price of an investment. They are entered as a percentage of the investments initial purchase price. For example, if you buy an ETF at $10 per share, and add a 5.0% TSO, if the price were to fall to $9.50, it would trigger a sale, thereby limiting your loss to 5.0%. That describes a stop order. However, if the price of the investment were to rise, the stop price would rise with it, maintaining a 5.0% lower bound.

Therefore, if the price of your investment rose to $15.00 per share, assuming it hadn't triggered a sale beforehand, the new stop order would be $14.25, which is 5.0% below its current price of $15.00. At this point, the new stop order of $14.25 would be above the the original purchase price of $10.00, hence, if the price were to decline and hit $14.25, it would sell and you would have a profit of approximately $4.25 ($14.25 - $10.00 = $4.25) per share.

Trailing stop orders are a great way to place a safety net under a position. However, it may not always work as planned. For example, what if the price falls and hits the TSO, triggers a sale, and then the investment subsequently rises? Hence, it’s important not to set your TSO percentage so low that normal volatility would trigger a sale. In essence, I view TSOs as a way to protect against, or limit losses in the event of a more serious decline. Therefore, it's important to determine the proper percentage for your TSOs and consider how it may change as volatility rises and falls. To analyze this, I used end-of-day data for the Dow from Jan. 1, 2004, to Sept. 18, 2013, calculating the percentage loss for all peaks to valleys which were close to, or greater than 5.0%. Hopefully this will provide insight as to where I should set my TSO percentage.

I'll discuss this more next week.

Until then, thanks for reading and have a great week!

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