How ETFs Could Help Fuel A Stock Market Crash [Direxion Daily Small Cap Bear 3X Shares]

How ETFs Could Help Fuel a Stock Market Crash

“ETFs play a much larger role in the market than people realize,” Gilani said, and that they have a built-in risk few consider.

He worries that in a stock market crash, the way ETFs are structured could add more fuel to the selling momentum. That’s because the ETF price at any given time doesn’t always match the precise value of the securities it holds, unlike a mutual fund, which recalculates its net asset value (NAV) at the end of each trading day.

This can become a problem in a stock market crash as investors start selling large numbers of shares of the ETF, Gilani said. Since the amount of securities that an ETF holds needs to correlate to its shares – it’s not a stock, there’s no fixed float – the ETF must start selling shares of the underlying securities.

That feeds the overall market sell-off, which drives more selling of the ETF, amplifying the stock market crash.

Add in what the HFT operators will most likely do in this scenario – pull the plug on their computers and suck out most of the market liquidity – and it’s easy to see where real panic could set in.

“There are ghosts in the machine,” Gilani said. “We’ve already caught glimpses of them.”

So what does this mean for investors?

What Investors Should Do Now

While Gilani says a correction is coming soon and that the market has structural flaws that could make it worse, he knows that the long-term outlook is still strong as we’re in a “generational bull market.”

While preparing for any kind of stock market crash is a challenge, Gilani says dumping everything is a bad idea.

“I’m a strong believer that you have to be in it to win it,” he said.

The most important thing for investors to do, Gilani said, is to always have a plan: “You need to know when you’re going to get out, or add more if stocks go down.”

As for specifics, he recommends big cap, high-dividend stocks.

“They’ll hold up in a big sell-off, and will go back up when the market recovers,” he said. “And in the meantime, you’ll get the dividend income.”

For those comfortable with options, Gilani also recommends buying puts, which he likens to buying insurance.

One policy endorsed by all Money Morning experts is the use of trailing stops, which limit losses. Even then investors need to keep an eye on the market so they can get back in at bargain prices.

“Stocks need to clean out some of the dead brush,” Gilani said. “But you need to stay in because after that there’s nowhere to go but up.”

Money MorningWritten By David Zeiler From Money Morning

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