Q: Should I Add a Stop-Loss Order to the ETFs in my Portfolio to Protect Against Loss?
A: The short answer is 'NO!'
Unless otherwise advised in a notification email, during periods of heightened risk (most recently during the Coronavirus pandemic in 2020), most of our strategies use weekly determinations of market exposure and ETF selection. We then make all trades on Mondays (avoiding the high-volatility opening and closing hours) – after the weekend update of each model uses the average price from the previous Friday to make its decisions. You should never over-ride the recommendations of your model if you want to repeat your model's exceptional performance.
The longer, more detailed answer is that while most of our Premium Strategies include Stop-Loss criteria in their weekend updates, we NEVER use INTRADAY Trailing Stop-Loss Orders (as offered by your broker). During periods of increased threat to stocks, we may use DAILY CLOSING PRICE stop-loss orders, which are executed the following day, but we never use intraday stops.
Intraday Trailing Stop Loss Orders are what most brokers offer to their clients. The reason we don't use our broker's intraday stops is that there is far too much noise in intraday prices, which often results in sales at prices far below what we were expecting. Our quantitative assessments are done using Weekly Closing Prices (and sometimes Daily Closing Prices)— as opposed to Intraday Prices during the week. At the close each Friday, the price of stocks, bonds, and ETFs are far more indicative of the fair price of that asset than it is during any given trading session throughout the week.
During the week, traders often test extremes and push the boundaries of price patterns, which can cause a great deal of volatility. An intraday Stop-Loss Order with your broker will execute a trade to close positions the moment an ETF drops a single hundredths of a point below the percentage or dollar amount you set as its Stop-Loss Criteria, when you didn't really want it to close it out. Mid-week, intraday volatility can cause inadvertent trades that are—almost by definition—at a low, thereby locking in a temporary loss instead of remaining at a short-term low that is often reversed.
On the other hand, high-volume professional and institutional short- and intermediate-term traders often close all their open positions going into the weekend to avoid headline risk. Buyers and sellers are more likely to close those positions at a fair price going into the weekend, avoiding extremes, and subduing volatility from one week to the next. For this reason, each Friday's closing price has the highest quality and are most accurate when it comes to the quantitative assessment of price trends and inflection points.
Marketmakers, while providing liquidity to the market, are also looking to make as much money as possible from their omnipotent position in the middle of retail trades. Read this article on Investopedia to learn about a few marketmaker tricks (there are many more!), which often take advantage of intraday stop-loss orders.
Example Trade — Intraday Prices vs. Closing Weekly Prices
Let's say you set a stop-loss price on an ETF that is about 1% below that ETF's 100-day Moving Average. The 1% adjustment allows for some overtrading or sloppiness that can occur in equity prices. From a weekly-closing price perspective, this is equivalent to the 20-week Moving Average (the 100-day average divided by 5 trading sessions in a week).
However, during the week, it's not unusual for traders to exchange positons sloppily in the heat of battle. In the short-term, an ETF's intraday price can easily dip (for example) -1.02% below its 100-day moving average, but when the week is ending, the price of that ETF is back above the 20-week moving average. The first scenario would close the trade at a short-term low, while in the second scenario—using weekly prices from Friday's Close—you would still be holding the ETF going into the weekend.
This article will provide you with several good reasons to NOT APPLY your Broker's Stop-Loss Order to the ETF-based positions in your systematic investment model. We will show you how market makers and other insiders regularly turn everyday investors using Stop-Loss Orders into sitting ducks – which those insiders take advantage of to generate easy profits. Most importantly, adding a mid-week, intraday Stop-Loss Order to your ETFs will consistently cause significantly decreased performance. Read on to learn why…
What is a Stop-Loss Order?
Take a moment and think about what a Stop-Loss Order is really about. Stop-Loss Orders require setting an arbitrary percentage below which you are going to sell a position – based solely on your perceived financial pain threshold, assessed at a particular moment in time. An investor's pain threshold is a level where they think they will start feeling uncomfortable if a downturn begins. There is no systematic basis for these sales—they are entirely arbitrary.
Tomorrow or next week – as market conditions change – your pain threshold may be far different than it is today when you enter the order. Moreover, setting a stop-loss amount in this way is certainly not systematic. Our extensive systematic testing of Intraday Stop-Loss Orders demonstrates that they are neither prudent nor effective. This article will tell you why adding intraday Stop-Loss Orders to prevent mid-week losses are a terrible idea, and we hope that after reading this article, you will vow to never use your broker's stop-loss orders for the rest of your investing life!
Stop-Loss Orders Applied to a Popular ETFOptimize Model
Let's get right to the point that's established as the headline of this article. This section will show 1) one of our most popular ETF-based investment strategies (Adaptive Equity+ (2 ETF) Strategy) in standard format as offered to subscribers, then we will show you 2) the effect of adding a -15% Stop-Loss Order to the strategy, and finally, 3) the impact of adding a tighter -10% Stop-Loss Order to the model.
In standard format, from inception on July 1, 2007 through January 18, 2020, the model has provided an Annualized Return of 37.76%. The investment of $100,000 in July 2007 grew to $5,571,994 by 2020 (12.5 years). *Past performance may not be indicative of future results.
Adaptive Equity+ (2 ETF) Strategy - No Modifications: (37.76% AR)
Chart 1: This is the Adaptive Equity+ (2 ETF) Strategy with performance since inception as it exists on January 18, 2020. It has a near 38% Annual Return.
15% Stop Loss Order
If our client were to add a -15% Stop-Loss Order to the ETFs in their model, they would see a -8% per year annual decline in performance, and the terminal amount (the total amount this portfolio was worth after 12.5 years of growth) would DROP BY HALF – from $5.57 million in Chart 1 above to $2.65 million in Chart 2 below – a decline of $2.9 million (-52%). The only difference between these two models is that a 15% stop loss was added.
Adaptive Equity+ (2 ETF) Strategy - 15% Stop Loss Added: (29.85% AR)
Chart 2: Same Strategy with a -15% Stop-Loss Order added. The Annual Return drops by about -9% to 29.85%. The Terminal Amount drops from $5.6M to $2.6M.
10% Stop Loss Order
Continuing the exercise, if the client were to add a tighter -10% Stop-Loss Order to the ETFs in their model, they would see a -21% per year annual decline in performance (to about 17% AR). The Maximum Drawdown would INCREASE to -34.45%, even though we are applying an even tighter Stop Loss. The terminal amount would drop NEARLY NINE-FOLD, from $5.572 million to just $713,000 – a decline of -$4.86 million (-87%).
Adaptive Equity+ (2 ETF) Strategy - 10% Stop Loss Added: (16.95% AR)
Chart 3: The same strategy with a -10% Stop-Loss Order added. The performance drops by 9-FOLD to an AR of 17%. Investment growth drops from $5.6M to $713,000.
It is pretty clear from these backtests that appending a Stop-Loss Order to the ETF investments selected by your model is a clear and present danger to the results you will achieve! Instituting Stop-Loss Orders with your broker usually has the effect of selling your positions at a temporary low—i.e., Buying High and Selling Low—the exact opposite of successful investment methods!
The Problem with Using Intraday Prices
Over the years, we have run thousands of backtests on trailing and entry-based Stop-Loss Orders, and they invariably result in less profit and frequently higher drawdowns than if the investor uses their strategy's rules as designed. While it may seem counterintuitive that a Stop-Loss Order would cost you money, it is a logical result of equity prices being very *noisy.*
Prices being noisy means there is a lot of mostly inconsequential ups and downs during every market session as investors test the high and low thresholds of market prices – levels that may only be important to a select (but often material, volume-wise) group of short-term day traders. Instead, our strategies always base decisions on the weekly closing prices on Friday, which have far less noise, usually represent more accurate estimates of investors of the appropriate price, and, for our purposes, are the only prices that matter.
What If the "Bottom Drops Out Midweek?"
Suppose the market has background conditions that constitute a significant risk to investments at any given time while stock prices continue to rise (such as during the COVID-19 Pandemic). In that case, ETFOptimize will temporarily apply a sophisticated Closing Stop-Loss policy on each ETF in our models. These Stops use composites of multiple indicators, based on the closing price of an ETF each day, and not a single determinant based upon an ETF's price crossing a fixed, subjective line in the sand.
An investor could argue that if the bottom drops out of an ETF in the middle of the week, a stop loss will prevent losses in that event. However, 99% of the time that's just not accurate. One reason is that the "bottom doesn't drop out" of diversified indexes and ETFs – as can occur in individual stocks when unexpected bad news strikes.
This robustness is one of the main reasons that more than $1 Trillion per year is pouring into exchange traded funds (ETFs), with much of that money coming out of mutual funds and individual stocks.
The shares of dozens, hundreds, or even thousands of different companies are held in a single ETF ticker, and it's highly unlikely that all those companies will collapse at the same time. It would require a national tragedy of enormous proportions to cause something like that to occur – an event of such epic proportions that it will affect the earnings ability and business models of thousands of American companies across all sectors and segments of commerce. That's highly unlikely, short of a nuclear holocaust or a return of the plague.
Assuredly, somebody will bring up the Flash Crash—a brief, 20-minute period in 2015 when many ETFs lost half their value at the open, then recovered it all back by noon. At the time, it was horrifying for many ETF investors. For example, the iShares Select Dividend ETF (DVY) plunged -36%, Guggenheim S&P 500 Equal Weight (RSP) dropped -42% and iShares Conservative Allocation Fund (AOK) tumbled -50%.
In the 2015 crash, there were 1,278 trading halts involving 471 different stocks and ETFs. There has never been a reasonable explanation for the glitch that caused this wild price action. Generally speaking, most investors consider it to be an anomaly—not a systemic risk inherent to ETFs.
If there is ever another "Flash Crash,' your best policy is to ignore it. We certainly hope you don't set yourself up to lose an enormous amount of money – as many thousands of investors did in 2015 – because you have a Stop-Loss Order on your ETFs. Those Stop-Loss Orders are likely what caused the Flash Crash to intensify so much after the initial, mysterious decline. If your positions drop by -40% to -50%, as occurred in the 'ETF Flash Crash,' by all means – don't sell! If you have any cash on the sidelines and your quantitative strategy is saying you should remain invested, then you should put that money to work and Buy, Buy, Buy at an enormous discount!
Stop-Loss Orders tend to do the opposite of what you want; they LOCK IN LOSSES – rather
than prevent them – by selling your position on a temporary tick lower.
Even after the fast-paced, 1987 selloff of -33% (the majority of which occurred in a single day), stocks recovered in the following weeks, and a couple of months later, were 20% higher than where they stood before the selloff. Equities went on to climb higher for the next 13 years; until the dot-com bubble burst in 2000.
A savvy investor should have stayed fully invested if that's what his/her quantitative strategy was recommending in 1987. Our back tests show that our models would have been in defensive positions just before the 1987 selloff (which was really a correction of overextended prices), so as usual, they would have gained ground during the selloff rather than lost money – then switched to aggressive equity positions a few weeks after the selloff to capitalize on the robust 60% run higher over the next two years.
How a Stop-Loss Order Can Make You a 'Sitting Duck'
It's a sad but true fact that some unscrupulous market makers will temporarily extend prices downward if a typical stock-loss threshold is just a bit lower than the current price of an ETF or stock. For example, let's say that an equity has slumped for the last few days and is currently selling for $63.50, with its 50-day moving average not far below, at $59.69. The ETF represents an industry that is on stable ground from the perspective of profits, it's in a long-term uptrend, and there are no fundamental problems in the foreseeable future.
However, opportunistic market makers might subtly manipulate the price of that stock or ETF down to $59.68, then buy a huge position as tens of thousands of Stop-Loss Orders are triggered and with quiet glee as the equity quickly recovers – logging a 6% gain in seconds. The market maker's boss is happy, but you have a loss on that trade because you had a stop loss just below the 50-day moving average. If you set your stop loss at the 100-day or 200-day moving averages, they will take advantage of you there too!
Don't believe it happens? Please check out the price chart of nearly any stock or ETF when they are hovering near a significant moving average. They will frequently drop just below that moving average, and moments later are back above it while hundreds or thousands of investors instantly lost a bundle because they had a stop loss at a common 50-day SMA level. It's a typical way that insiders and smart-money investors take advantage of amateurs.
Chart 1 below shows an example using the S&P 500 index at the 50-day simple moving average (SMA) and 50-day exponential moving average (EMA). The exponential moving average (EMA) more heavily weights recent prices, allowing it to react quicker to price movements. Both the EMA and SMA are about equally popular, depending on the need. These two 50-day moving averages are a common threshold where insiders often take advantage of amateur's Stop-Loss Orders because they know that many will place a stop loss just below that well-used level.
Also, the 50-day moving average is not so bearish that the insider risks the ETF or stock going into a deep selloff to lower levels (such as can occur at the 200-day or 250-day moving average), and is not so tight that it's difficult to predict when there will be a quick cross (such as the 10 or 20-day moving average).
However, these cherry-picked, Stop-Loss based trades occur at virtually every significant moving average, across thousands of stocks and ETFs, and on every timeframe that is used regularly by traders; daily, weekly, hourly, 15-minute, five-minute, you name it. Regardless of the timeframe, less experienced investors routinely use simple moving averages as rule-of-thumb, stop-loss levels. However, we never use stand-alone Moving Averages as buy or sell signals, and neither should you.
Chart 1: Stop-Loss Orders at moving average levels used by a significant volume of investors are regularly harvested for millions of dollars in profits by insiders.
The market-maker, block trader, market insider – or these days, often a well-designed, high-frequency trading (HFT) program – will make relatively small purchases to inch a position's price down to just below the 50-day SMA or 50-day EMA (both are popular) or other significant moving average using different time frames, causing a flood of Stop-Loss Orders to trigger depending on the popularity of the stock or ETF. The insider or HFT program then reverses its approach and scoops up these forced, automated trades with a massive amount of open buy-limit orders, reaping risk-free profits as the position returns to more normal trading levels in the following hours and days.
In Chart 1 above, you can see that there are a dozen times on this daily chart during 2017 that the S&P 500 was pushed to just pennies below its 50-day SMA or 50-day EMA. Then, when those orders were filled as the market maker scooped up the automated stop-loss trades, the index rapidly climbed higher and big profits were scored. The larger the market capitalization, the harder a trade is to manipulate, but look at all the potential daily trades at the 50-day moving average in 2017 on the S&P 500 – representing the largest, blue-chip stocks in the US. On any given day, thousands of equities and ETFs are hovering near significant moving averages – perfectly set up for this drop-and-pop scam.
They repeat the process – across thousands of stocks and ETFs every single day – and you have a money machine that consistently takes advantage of unwary, amateur investors. Add up all those trades, and a professional trader can (and do) have a comfortable, multi-million-dollar annual business based on arbitrage of amateur's moving-average-based Stop Loss Orders.
Instead, Use a Well-Designed, Quantitative Investment Strategy
Instead of using a Stop-Loss Order – which at best is very blunt and ineffective tool, and might even make you a sitting duck for the profit of others – to protect yourself from significant loss, it is far more prudent to put your investment decisions in the hands of a carefully crafted, emotionless, quantitative decision system that is constructed well in advance of market turbulence – rather than selling at a price only selected because that's all the temporary downturn you felt you could emotionally handle at the time you enter the order. Granted, a Stop-Loss Order may be better than panic selling, but probably not by much...
Instead of an emotional approach to selling, considered using a systematic strategy (such as those offered by ETFOptimize), which we construct using different composites from more than 50 different data sets from a wide variety of disciplines, which instantly analyze and interpret the readings from macroeconomics, stock fundamentals, internal market breadth, and technical signals of both the equity and fixed income markets.
It is impossible for a blunt percentage or a sell rule based on an ETF's entry price to match the benefits of extensively-considered rules based on solidly grounded investment principles – confirmed by extensive backtesting and live, out-of sample performance – developed into sophisticated algorithms in an ETFOptimize quantitative strategy. Adding a Stop-Loss Order to your positions, when triggered will negate all the systematic considerations of these carefully constructed quantitative strategies.
Our recommendation is never to use a trailing or entry-based Stop-Loss Order. Also, we suggest you try to avoid monitoring market events and investment-related news – which is inherently designed to elicit an emotional response from its viewers. Like traffic slowing on the freeway with passengers craning their necks to see the results of an accident, television channels such as CNBC gained an 800% increase in viewership during the 2007-2008 Financial Crisis, as a result of the constant airing of threats of existential danger espoused by seemingly every guest.
Why not allow the ETFOptimize strategies to do all the market monitoring and make all the stressful decisions, while you check your model on Sunday evening or Monday morning to get performance updates and see if there are any changes (you should fill recommended ETF trades at mid-day on Monday).
Otherwise, you should sit back and relax – with a patient, long-term perspective, knowing that you have the best investment approach that's available – constructed by a design team that has more than 50 years of collective investment and strategy-design experience. Instead, enjoy all the wonders and exciting challenges that your life has to offer, and don't waste another precious minute on the TV talking heads or monitoring market charts.
Not Yet an ETFOptimize Strategy Subscriber?
Get a Strategy Subscription and Weekly Market Analysis - FREE!
The ETFOptimize quantitative investment strategies have a proven track record of consistently high-performance success over long periods. Our premium model strategies have provided an average annual return of 30.53% since their inception – which is a multiple of more than quadruple (415%) the long-term annual return of the S&P 500, and more than eight times more than the index' return since 2000. The ETFOptimize strategies, collectively, have beaten the S&P 500 in 64 of 66 years (97%)!
The ETFOptimize strategies operate using our proprietary, quantitative financial-analysis programming that has been continuously upgraded and refined over the last 25 years, accompanied by high-speed computer servers and high-quality, point-in-time investment and economic databases. As ETFs were developed and became so incredibly popular, we've adapted our approach to embrace these instantly-diversified products.
Why not look over our strategy lineup now and see which one is the best fit for you? It's actually straightforward and affordable to put a high-performance investment strategy to work for you every week of the year. The ETFOptimize models are available by subscription starting at just $9/mo.
(We even offer a Free strategy for those who would like a long-term trial before subscribing).
Look around the Internet; we don't think you'll find a superior approach to investing – offered at such an exceptionally low cost, and making consistent, high-performance investment results affordable for even the smallest investor. You keep your money in your account and follow our clear instructions for trades, which occur only about three times per year. We provide you with weekly updates of your strategy and an analysis of the market that always tells you what's critically important.
Plus, you can subscribe without risk because each model is backed by a 60-day, 100% Moneyback Guarantee if you decide that algorithmically based strategies are not your cup of tea. Our firm, Optimized Investments, Inc., has an A+ Rating with the Better Business Bureau and a perfect record of satisfied customers – no complaints – since the BBB began reviewing our firm, which was founded in 1998.
Take a moment to sign up for the strategy of your choice now – while all the benefits of a quantitative approach are fresh in your mind. You can get started for less than 50-cents a day with a very low-risk, high-profit investment strategy that produces solid performance through thick and thin – in any type of market environment.
Moreover, remember that you have nothing to lose – if you change your mind anytime in the first two months – for any reason (or no reason at all) – just let us know and we'll return every penny you paid! Visit our ETF Investment Strategy Suite today to select the strategy that's perfect for you:
Visit our ETF Investment Strategy Suite