Using Trailing Stop Orders on ETFs in Real Portfolios: How They’re Working

Several months ago, I wrote about a new investment strategy I had implemented using ETFs and trailing stop orders (TSO). Now that I have used it for a while, I believe it's a very beneficial component in money management. In this post, I'll provide an update. 

The Strategy: A Brief Overview

In the event you missed past blogs where I addressed this particular strategy, here's a brief summary to explain. Let's assume you have a portfolio with 10 holdings, some which are risky and some which are not. The overall risk of the portfolio will be determined by the allocation to each. Given this information, here's what we may conclude: If the markets became highly volatile, the conservative assets probably wouldn't hurt the portfolio. Therefore, I'm not concerned about these holdings and a mutual fund would be appropriate.

The risky holdings could cause great damage to the portfolio during a market crisis. Hence, if the portfolio’s stock exposure was 100% mutual funds, and the stock market was collapsing, the sales price of the mutual funds would not be determined until the end of the trading day and you would've absorbed the entire day’s loss.

On the other hand, ETFs may be sold at anytime during the trading day. This strategy takes full advantage of an ETF’s pricing flexibility. Therefore, for the majority of the portfolio’s stock exposure, I'll use ETFs and add trailing stop orders to protect against a large loss.

In short, if the stock market were to collapse, the TSOs would trigger a sale on the ETFs before things got too bad. This will eliminate the possibility of a large loss.

Six Keys to Using TSOs

There are a few keys to using this ETF strategy: 

Key #1: Invest after a decline.
Watch for sectors or categories that have been out of favor and have corrected. I have no precise loss percentage at which I will buy in, but I will only do so after a decline. 

Key #2: Establish the TSO percentage at a level which you believe will not trigger a sale due to normal market fluctuations.  
If you get this correct, you will capture all of the upside while protecting the downside. 

Key #3: Select good quality ETFs.
This, like much of the investment process, is somewhat subjective. Because of time and space constraints, we will discuss this in a later post. 

Key #4: Choose an appealing theme.
Investment sectors, geographic regions, investment styles, etc., fall in and out of favor at various times. For example, I like to buy companies that repurchase their own shares because this increases the value for the remaining shareholders. This is also a theme which is working well. 

Key #5: Use a mix of passive and active strategies.
The best choice depends on the particular sector, style, etc., you are considering. Morningstar Advisor magazine's February/March 2014 issue (not yet available online) published several good articles which analyzed the areas where active management has a greater probability of outperforming a passive index. 

Key #6: Consider tweaking your TSO percentage as market conditions change.
This will also depend on the volatility of the specific ETF and where your TSO price is relative to its market price. 

My Results Thus Far?

Last year, the results of using this strategy were mostly positive. I was also doing a lot of tweaking. In short, we earned as much as 10% and lost no more than 2% from late June through mid January 2014. There were two ETFs which had a small loss. In each case, the loss is attributed to not waiting for a decline before investing.

This year, I've bought six different ETFs from January 31st to February 7th. Each has a nice gain thus far ranging from 3.0% to 5.9%, in approximately three weeks. To summarize, this will be the first full year with this strategy and I like the results to date. I'll keep you posted. 

Thanks for reading and have a great week.

 

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