Chuck Jaffe of MarketWatch recently wrote about the danger posed by the next ‘flash crash’ and how retail ETF investors often mistake limit orders for protection:
The ‘flash crash’ turned the stock market on its ear during one violent trading day a year ago, but many investors are still vulnerable to the market’s next bungee jump. Their mistake: stop-loss orders on exchange-traded funds — a move that puts shareholders directly in harm’s way.
Stop-loss orders come in a number of varieties, and can be a smart strategy for protecting profits. The fundamental idea behind them — a set price to exit a security — makes sense, even for a long-term investor who tries not to be swayed by momentary market movements.
That said, the flash crash on May 6, 2010 exposed how the best intentions can create real problems.
Technically, a stop order is an instruction to sell a security at the current market price. Thus, if your shares of XYZ trade at $100 per share and you want to cap losses at 20%, you could set a stop-loss at $80 per share; if the price falls to that level, the order triggers.
Stop-loss strategies are part of the appeal of exchange-traded funds. ETFs are mutual funds that trade like stocks, priced minute by minute; if you want in or out, you can get the market price the instant you execute the trade.
In contrast, traditional mutual funds are priced at the end of the trading day. Thus, once the market opens — even if you sell after five minutes — you’re along for the ride day’s ride no matter how crazy things get.
Read the rest of the article at MarketWatch.
Sources:
“ETF investors at risk in next ‘flash crash’” Chuck Jaffe. Marketwatch, 5/8. https://www.marketwatch.com/story/etf-investors-at-risk-in-next-flash-crash-2011-05-08
