Two well-known rules of legendary investor Warren Buffett are to never lose money and to never forget the rule about losing money. These rules essentially sum up one of the most important aspects of investing: capital preservation.

One of the most effective ways to protect capital is by using a stop-loss order. Investors typically associate stop-loss orders with stock trading and investing, but they can also be useful when trading exchange-traded funds (ETFs). There are market participants who believe stop-loss orders are not overly applicable to ETFs, as they generally track an index that diversifies holdings, reducing volatility and risk.

When investing, it is always prudent to expect the unexpected, especially in the age of high-frequency and automated trading, which played a significant part in triggering the flash crash in 2010 that caused the U.S. major stock indexes to fall approximately 9% in a matter of minutes before paring a large portion of the losses.

There are particular market environments and circumstances that require wider placement of stop-loss orders to help avoid a premature exit of a position or undesirable execution. Consideration needs to be given to volatility, liquidity and events when determining how wide to place a stop-loss order for ETFs.

Volatility

Volatility is visually seen in the financial markets as substantial and rapid price swings. As volatility increases, profit and loss potentials also increase. A common measurement of volatility that tracks the S&P 500 is the Chicago Board Options Exchange Volatility Index (VIX). As of 2016, a VIX reading of 30 or above typically indicates the S&P 500 Index is experiencing a period of volatility.

An ETF's beta measures its volatility compared to the market as a whole. A beta greater than 1 indicates that the ETF's price is typically more volatile than the market. It is prudent to place wider stop-loss orders when the VIX is spiking or the ETF has a beta greater than one. The iShares NASDAQ Biotechnology ETF (NASDAQ: IBB) has a beta of 1.07, and the SPDR S&P Biotech ETF (NYSEARCA: XBI) has a beta of 1.4. Wider stop-loss orders in these ETFs may therefore be appropriate.

Liquidity

Liquidity is a key consideration when determining stop-loss placement. Low liquidity may lead to a greater bid-ask spread and slippage. Placing a stop-loss at a specific price does not guarantee the order is filled at that price. An investor may place a stop-loss order at $30 but receive an execution at $29.75 if liquidity is insufficient at $30. The broker executes the order at the next best available price, in this particular example at $27.75.

Leveraged ETFs often have low average daily volumes that require wider stop-loss placement. The ProShares Ultra Gold Miners ETF (NYSEARCA: GDXX) has an average daily volume of 8,889, and the ProShares Ultra Utilities ETF (NYSEARCA: UPW) has an average daily volume of 3,787. These ETFs are practical examples where a wider stop-loss may be appropriate.

Events

Events include general or specific news and earnings announcements that have the potential to move the price of a specific stock, sector or market as a whole. Often, news can surprise the market and is difficult to plan for, like a surprise announcement that affects a particular stock or sector. Events that are likely to increase volatility such as company earnings and economic data can be planned for in advance with information relating to these events readily available online.

A large market capitalization company's earnings often has a flow-on effect to stocks in its sector or industry. Stocks in the biotechnology sector are particularly prone to increased volatility when the Food and Drug Administration (FDA) approves a new drug or makes an industry-related announcement.

Investors need to be mindful of these factors and place wider stop-loss orders on ETF positions before the event, especially if it is not a day-trading position. A tight stop-loss in these scenarios may result in the ETF gapping well below the stop-loss order, receiving an undesirable execution or a premature stop out.

The Bottom Line

Nothing is more frustrating than having a position stopped out by a penny and reversing direction. When determining how wide to place stop-loss orders on ETF positions, investors need to consider volatility, liquidity and events. The VIX and the ETF's beta can be used to help gauge volatility. An ETF's liquidity helps determine the likelihood of slippage when determining stop-loss placement. Events such as earnings and FDA news can cause significant gapping and must be considered when placing a stop-loss.

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