The present financial and geopolitical climate has many investors nervous. They want to invest, but they are also concerned that a sudden market drop could quickly wipe out any gains.
With the market trading near all-time highs and uncertainties both here and abroad, investors understandably worry. Naturally they’d love to ride the market to new highs while maintaining a plan just in case things reverse course. After all, the stock market seems to be pricing in almost certain expectations of growth.
But what if the economy doesn’t grow as planned? Is there a way to invest and also include a protective component in your portfolio?
[See: 7 Ways to Trade Volatility With ETFs and ETNs.]
Some investors who want to stay invested during good times and also have downside protection in case things turn south can implement what’s commonly known as a “stop-loss” strategy. A stop-loss is a trade instruction on an investment that is entered into the order at a specific price below a stock’s current market price. This means the order is pending and will only be executed if or when the stock actually trades at or through that price.
So, if the stock value continues to go up, the stop-loss order will remain but not be executed, thereby allowing investors to enjoy the gains. However, if the stock goes down in value and hits or crosses the stop-loss price, the stop-loss order then becomes a market order and will be executed. While this strategy is not entirely foolproof and can still mean losses for an investor, it can offer some measure of price protection that may allow some investors to sleep better at night.
It is critically important to note that you cannot be guaranteed your stop-loss price. Instead, your trade will become a market order when the stop-loss price is breached. Why? In actuality, it’s quite possible, and in some cases even likely, that the stock will not actually trade at the exact stop-loss price but rather “gap” below that price level. If this happens, once the stock trades through the stop-loss price, the stop-loss trade becomes a market order and will then be in the queue to be executed. The actual trade may happen a few pennies or even many dollars below the entered stop-loss price. That is why investors using this strategy need to be mindful of this possibility when setting a stop-loss price — especially with volatile securities or during particularly volatile markets.
When considering a stop-loss strategy, investors also should know that stock prices may bounce around in any trading session, potentially triggering a stop-loss before ending the day at a higher price — leaving the investor unable to capture the gain. In other words, this strategy cannot offer price protection under every market fluctuation scenario.
[See: 7 ETFs for a Solid Portfolio Defense.]
It may be helpful to remember that any stop-losses do not have to be an “all or none” decision. An investor might choose to place a stop-loss on a portion of his or her shares once the investment reaches a certain level of gain. For example, if an investor were fortunate enough to have doubled their money on a stock, he or she might want to place a stop-loss on half of their shares at that price. This strategy would permit them to play with the “house’s money,” or allow flexibility with a portion of the shares, should the stock price drop.
A specific example helps illustrate how this approach could help an investor toward their plan goals.
Let’s say that in response to Federal Reserve comments about the potential for more interest rate hikes during 2017, an investor was motivated to purchase the Vanguard Financials ETF (ticker: VFH) with the belief that earnings of these lending institutions would increase and therefore underlying share prices would rise. On Election Day, these shares were trading at about $50.75. By March 1, these shares reached a high of nearly $64 per share, a gain of more than 25 percent in just over three months. Believing that this upward move was pricing in too much optimism too quickly, an investor may want to put a stop-loss on some or all of the shares, perhaps at $60 or even $58, to protect those early gains.
As with any buy or sell strategy, investors should be careful when entering trade instructions and be certain they understand how this decision fits within their overall financial plan. The best financial plans not only expect, but prepare for market volatility. Rather than trying to “time” the markets’ fickle gyrations, financial plans can potentially take advantage of these times and allow an investor to rebalance toward their long-term goals.
[See: U.S. News & World Report’s 10 Top-Ranked ETFs.]
Information contained herein is from sources the author considers reliable, but is not guaranteed, and the author is not soliciting any action based upon it. Any opinions expressed are those of the author, based on interpretation of information available at the time of original publication of this article. These opinions are subject to change at any time without notice. Investors should consult their financial and/or tax advisor before implementing any investment plan.
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The Pros and Cons of Implementing a Stop-Loss originally appeared on usnews.com
