When the Markets Waver, Dust Off Your Stop Loss

On a day like today, when the Dow is down nearly 200 points, it's worth thinking about your stop loss. Do you have one? Is it simple to execute? Most importantly, will you use it? The most foolproof stop loss does no one any good if it's just idling there, often thought about but never actually employed.

 We've experienced a tremendous rally since March 9, but it's not cause to be lulled into complacency. We can and will see corrections again in the markets, and it's impossible to know how long they'll be. This is why it's important to have that point at which you know you will sell in order to protect yourself from either erasing any gains you may have made or from suffering greater losses.

A simple exit strategy we suggest is selling either when a position drops below the 200-day moving average or 8% off the recent high, and several ETFs have hit or are getting close to hitting those points. The 8% point is high enough that we’re not in and out frequently, low enough that a big loss would not have to be sustained before selling. [How to use stop losses and a moving average strategy.]

We’re not predicting anything about the markets. The losses we’ve seen in the last month could end tomorrow or there could be more in store. This is why we’re big proponents of having an exit strategy. If you’re looking to follow the trends and participate in the upside while avoiding much of the downside, this is one way to do it.

Two of the best reasons to have a stop loss are:

• They remove the emotional aspect of selling.
• They eliminate the question millions of investors have asked themselves: “How do I know when it’s time to let go?” If you have a stop loss, this question is answered for you. All you have to do is execute it when the time comes.

The sell point you choose is up to you, but it’s important that it’s neither too small nor too large. A stop loss at 30% means that you would have to endure a 30% loss before you sold. A stop loss set at 4% means you’d be buying and selling pretty frequently and racking up fees that will eat into your returns.

There’s no guarantee that when you sell, the position you just sold won’t turn around and move higher. The purpose of trend following is to learn to focus on the next uptrend in another position, rather than regretting what was just sold.

For more information on trend following and stop losses, check out our new book, The ETF Trend Following Playbook.