Guarding Against Market Gyrations

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If ever there were proof of the perils of bad timing, it was in the three trading days between May 6, when the Dow plunged nearly 1,000 points, and May 10, when it jumped nearly 400 points by mid-morning.

Long-term buy-and-hold types can shrug these things off. But what about the poor folks who bet wrong on the plunge and missed the spike? Some traded at prices far less favorable than they’d expected.

This might be a good time for a refresher on trading techniques that can be used by stock and fund investors to avoid these pitfalls, and how those tricks can sometimes backfire. Market gyrations offer yet another reason for investors to favor exchange-traded funds over ordinary mutual funds.

The fastest and most common way to trade an individual stock is through a “market” order, in which the investor directs the broker to buy or sell immediately. You pay or receive the market price at the instant the order is executed.

Usually, this is pretty safe, as prices don’t shift all that much in the moments it takes to get a trade through the system, especially if you issue your own orders online rather than wait for a broker to do it for you. Market orders move very quickly because it’s not necessary to find a buyer or seller who specifies the same price you do.

Still, there is a risk you won’t get the price you had expected. And when markets are particularly volatile, you may end up buying or selling at a price you’d have rejected if you’d had a choice.

The solution is a “limit” order. A buyer orders a trade at or below a fixed level, a seller orders a trade at or above a limit. With limit orders, however, there is a risk the trade may not get executed at all, especially if prices are moving rapidly.

That may not matter if your stock is just bouncing around on an especially volatile day. But it can matter a lot if, for example, you want to sell, miss the price you’d hoped to get, and then have no choice but to issue a new sell order at an even lower price — lower than you’d have received with a market order. Similarly, a buyer using a limit order may miss the chance to buy and then face a price too high to be appealing.

Limit orders are best, then, for folks who can live with the possibility of missing the trade. They can be made just for the day or until canceled.

Another technique is the “stop-loss” order, where you order an automatic sale if the price falls to a given level, thus avoiding a deeper loss. This can be coupled with a limit, so you sell only if you can get a price at or above a given point.

Mutual fund investors are at risk in volatile market because their orders are not executed until after the end of the trading day, and at that point there’s no way to revoke an order. Mutual fund shares are priced at net asset value, or NAV, according to the close-of-trading values of the securities they own.

If you place an order at 10 a.m., the only pricing information you have is the NAV on the previous trading day, but you could end up with a different price after the close six hours later. Unfortunately, you cannot place limit orders with mutual funds.

That’s one reason so many investors like exchange-traded funds. These are mutual funds that are traded like stocks throughout the day. Like ordinary stocks, they are eligible for limit and stop-loss orders.

If you want to buy or sell an ETF at 10 a.m., you can. With a market order, you can be sure of trading within a few moments, avoiding market volatility that could affect a mutual fund’s price over the following six hours.

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