There’s no disputing stocks had a great first quarter – the S&P 500 tacked on more than 4.6%. In my Capital Wave Forecast service, we notched some nice double- and triple-digit gains, as well.

The market’s exchange-traded funds (ETFs), in particular, smashed records. Worldwide, investors plowed more than $197 billion into the popular vehicles, and this is coming after a record-breaking $390-plus billion ride in 2016.

[ad#Google Adsense 336×280-IA]All good, right?


See, the surging popularity of ETFs isn’t a bad thing, per se, but it’s taking place at the same time as a surge in passive investing.

And passive investing isn’t a bad thing, either, per se, especially not when stocks are going ballistic.

But the two together – passive investing and ETFs – could have an absolutely catastrophic impact on the markets and unprepared investors.

But, as I’ll show you in a minute, there’s a juicy, fast opportunity in this…

Investing Has Changed, Investors Have Not

As I said, on their own, both buying into ETFs and investing passively make sense.

But loading up passive investing portfolios with ETFs – especially benchmark and market index-tracking ETFs, which are precisely what passive investing calls for – is the equivalent of rubbing two sticks together over a mountain of dry kindling.

For the rapidly growing passive investing crowd, the new crusaders, and millions of former mutual fund investors who think there’s a new foolproof way to invest, the fact that markets go down may not be so worrisome. That’s because they think passive investing is some kind of miracle investing scheme that always makes money because fallen markets will rise again and, lately, seem to continue making new higher highs.

In the past, mutual fund investors were lured into parking trillions of dollars in fund families based on essentially the same premise.

Those investors (hopefully) know better now.

When the next market sell-off comes – and it is coming – passive investors are going to get hit hard with the reality of markets.

Now, investing has changed, but the pain investors feel when they see their life savings dwindling before their eyes hasn’t changed.

Passive investors will become active sellers, especially if the initial sell-off is unexpected (which it has to be at this point in the up-cycle), steep, and front-page news – not just in the financial press, either.

And that will be when the marriage of ETFs and passive investing strategies will start to burn the masses.

The biggest and most important ETFs are market benchmark indexed funds. That means they are market proxies, and that’s why passive investors park money in them.

Essentially, they are the market. And, if the market’s selling off, they will be falling in price while…

…the underlying stocks they hold will be going down in price.

And of course the ETFs themselves will be going down, because investors will be selling them.

And professionals and the authorized participants who work them up and down will be shorting them and the stocks underlying them.

See how it works? All that selling and shorting will cascade down upon itself, creating a negative feedback loop that could potentially devastate stocks.

It will be bad. It will be a vicious, expensive negative feedback loop.

But there are ways to protect yourself – and even make some money when that happens.

Remember Rule No. 1: Profit-Taking Is Painless

Since it’s impossible to time the moment when a sell-off is going to turn into a full-fledged rout, panic, or outright crash, my No. 1 rule for protecting any money exposed to market swings is to take profits.

As I always say, you never get hurt ringing the register. Never.

I use trailing stops. They are stop-loss orders that I keep raising as the stocks I own go up in price. Generally, I like having my stops about 10% below where my stocks are trading. As they rise in price, I adjust my stop-loss orders higher to prevent from giving back too much of my profit. Whether you use a 10%, 15%, or 5% stop-loss order from where your stocks are, it should be a function of how volatile they are on a daily, weekly, and monthly basis. The more volatile your stocks are, the more room you need to give them to move around.

Stop-loss orders that trigger and take you out of positions with profits are great. You ring the register and you have to look at that stock again to see if you want to get back in or find another position to ride.

Triggered stops force you to look at the market – the whole market – and see if the market is slipping and causing your stocks to trigger their stop-loss orders.

Watching the market is key to getting out of the way of a barrage of ETF selling, of passive investors becoming active sellers, and of you getting your head handed to you.

And at the start of a crash, being out of the market and looking to jump back in is a gift that keeps on giving.

It bears repeating: use trailing stops.

That’s how you protect yourself, so you can go on the attack to make some money while everyone else is running scared.

Turn a Terrible Feedback Loop into a Hefty Payday

If you see the “cascade” I explained happen – even if you think you see that about to happen – the smart move is to sell your ETFs.

If you misread the situation, you can always buy them back.

However, after a panic sell-off has begun and with the way the markets are these days, putting down stop orders could get you out a lot lower, a long way below where you put your stops down.

That’s why it may be a good idea to just sell at the market price as soon as you want to get out.

If you use stop orders, even if you’re using trailing stop-loss orders to protect profits, there’s no guarantee you’ll get out at your stop-loss price (or even close). We’re all limited by the new market realities and having stops get hit a lot lower than you would like is a reality.

Again, that’s why it’s better to be proactive and take profits when you can, hopefully before a big sell-off.

Another thing to know about keeping stop-loss orders regularly, as opposed to putting them down just when prices start to fall or using market sell orders once a panic has begun, is that you may have a case to ask for better fills if you had stop-loss orders down for a while. That’s just because brokerages may have a way to resolve some ugly fills in your favor. There’s no guarantee they will be able to do that, but you’ll have a better chance of them trying to improve your fills if you had orders down as opposed to trying a hard sell-off.

Hopefully, you’ll get out of harm’s way before the big waves of ETF selling and shorting lead to more selling, and shorting tanks markets.

If you’re quick enough (and you should always have a plan to do this in your back pocket), you can make a ton of money off the ETFs passive investors sell.

That’s because massive profits can come from buying put options on leveraged market ETFs that go up twice as fast as their underlying indexes, because when they go down, they will go down twice as fast as the markets do.

By buying puts on leveraged long ETFs, you don’t have to worry about any bounce or getting caught being short.

Just remember that markets can bounce back at any time, so if you buy put options and make a killing on a panic sell-off, don’t get greedy. A few hundred percent gain is a nice payday. Take it, or take half of your put options off and use a stop to sell the rest if markets bounce higher.

You’ll stay protected, but you’ll also be ringing the register while investors who didn’t act are singing the blues…

— Shah Gilani


Source: Money Morning