ETF Tracking: Looking Under The Hood Of Sell Stops

With the markets displaying some roller coaster similarities, this is as good a time as any to look at the process I go through in the event one of my sell stops gets triggered.

Also, how I might deal with the inevitable fact that, sooner or later, the TTI (Trend Tracking Index) will slice through its long-term trend line to the downside, thereby generating an all-out Sell for all domestic equity funds/ETFs.

Reader Nitin sent in the following question, which made me realize that my sell stop discipline is a little more than cold and hard percentages. Here’s what he had to say:

“Ulli: I read the update on your blog after the market activity of June 12. Overall, I agree with your approach to investing and tracking the market activity by some objective parameters to prevent getting run over by the bear market.

My only suggestion is that since this is not an exact science one cannot be too dogmatic about any specific approach or the numbers. This is not to say that we should not use these numbers that have stood the test of time but, they should be backed up by intuition, judgment wisdom and flexibility. The numbers can be used to get a general direction without being very precise about it.

For example, is it possible that in a dynamic process of market activity what worked in 2000 may not be applicable in 2007 or 2008? This is not a criticism about the current approach. I am just raising a caution about being too precise about the numbers.”

That is great feedback and allows me to be a little more specific about the process.

The key point about trend tracking is that you have to draw a line in the sand somewhere where you need to take a stance. In other words, at some point, action is required to both lock in some profits and avoid having your portfolio go down in a bear market.

You are absolutely correct that this is not an exact science, but not getting emotionally involved in the decision making process is crucial. Otherwise, there will always be reasons why “it’s different this time,” which is one of the big portfolio killers. It’s never different this time!

However, once we reach critical mass, meaning when either the 7% sell stop point is triggered or the TTI has crossed its long-term trend line, I do apply some wisdom gained from 20 years of experience in the trenches. Realizing that the possibility of a whip-saw always exists, I try to show a little flexibility.

Here’s how:

If one of our fund holdings drops below the pre-set sell stop, I don’t immediately place a sell order. I watch the next day market opening to see if prices are rebounding or are further sinking. If it is a neutral scenario, I may wait a couple of days for confirmation that we are actually heading further south before entering my sell order.

The same applies when the TTI drops below its long-term trend line. Here too, I want to get confirmation of further downside movement before selling and heading to the sidelines. However, I will not try to outguess the trend that is clearly reflected in the numbers. It will backfire as I have witnessed with a large money management firm that has been using trend following for 30 years.

First, during the rebound in April 2003 (after the bear market), they “outguessed” the trend and missed one of the greatest rallies in recent years. Same thing happened last year, when a trend emerged again after the May/June meltdown, and this firm stayed on the sidelines and is now staring at a market that has been on an uptrend for 9 months.

My point is that investment discipline coupled with some applied experience will be the best guide in surviving a tumultuous market environment.

About Ulli Niemann

Ulli Niemann is the publisher of "The ETF Bully" and is a Registered Investment Advisor. Learn more
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