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.