Whether stop-loss orders are a good idea when trading exchange-traded funds (ETFs) may seem like a simple question, so what you're about to read might seem unorthodox. But if profits are your goal, then you might want to consider the information found below.

Key Takeaways

  • Stop-loss orders often force traders out of ETFs at the worst possible times and lock in losses.
  • Professional traders generally use a combination of technical analysis and fundamental research to make decisions rather than relying on stop-loss orders.
  • Stop-loss orders can reduce losses on individual stocks, but they have limits even here.

ETF Stop Loss Equals Big Risk

This equation might seem backward at first. Suppose that you use a stop-loss market order on an ETF and that ETF temporarily trades at a steep discount to its net asset value (NAV). What’s going to happen? Your position is going to be sold when the ETF is offering a discount. You could use a stop-loss limit order. That way, your sale isn't triggered at the bottom. However, that’s still not going to be a good trade. You could also attempt to implement an arbitrage strategy, but this is complicated and would require liquidity, speed, and plenty of capital. There are also other order types that you can try, but they probably won't help much either.

Most ETFs track an index. Let’s use SPDR S&P Retail ETF (XRT) as an example. If XRT plunged more than 10% in a day, then you would know something was likely amiss. It’s simply not rational for all the stocks in the S&P Retail Select Industry Index to drop 10% or more at the same time—regardless of economic and market conditions. So, if this happens, it’s likely due to an error in a bearish and illiquid environment. That means XRT will probably move back up to its real value soon. This point is precisely where you would want to increase your position, not sell. Unfortunately, if you're using a stop-loss, then you're going to have no choice but to sell. Many people locked in losses with such stop-loss orders during the flash crash on May 6, 2010.

Amateur vs. Professional

If you have any association with the stock market, then you have likely come across all kinds of traders. However, we can narrow it down to just two types: amateur and professional. The amateur trader will have several screens running at once and TV pundit voices blaring in the background. The trader's feet will be rested on top of a mahogany desk while puffing on a cigar and looking at you with an air of superiority. That is the kind of trader who wears a suit while working from home and owns a luxury car on credit.

The professional trader is much more stealthy with wealth. These investors trade with discipline and conviction and without emotion. A professional might apply technical analysis but knows that deep research into fundamentals is also necessary. It's simply impossible to have real confidence in a position using only technical analysis. Self-discipline and the ability to manage risk through statistical analysis are the primary traits of a successful trader.

Calm and rational people who are good with numbers generally make the best traders.

A professional trader who sees that an ETF is trading well below where it should, based on research, will not despair and sell too soon. Instead, the professional will buy more shares incrementally. When you have real conviction, you have no fear when purchasing more shares of an ETF at predetermined intervals. Excluding leveraged ETFs and inverse ETFs, ETFs that track an index are not going to hit $0. Therefore, it's often only a matter of time before a rebound occurs. Of course, you must have the trend right, unless you want to wait a long time. Traders need to understand fundamentals, as well as technical analysis, to determine the trend. When both are bullish, you have the trend right.

Also, regarding dollar-cost averaging, you might want to consider never adding to a position below your lowest buy point. That might limit the upside potential to a certain degree, but it will preserve capital. Furthermore, set a capital allocation limit for each ETF. Also, diversify long and short so that you can make money regardless of which way the market moves. If you’re long on the highest quality and short the lowest quality, it’s only a matter of time before profits start rolling in.

Individual Stock Stop Loss Equals Reduced Risk

Stop-loss orders do have value, but only for individual stocks. Unlike most ETFs, individual stocks have the potential to go to $0, so a stop-loss can help keep you out of trouble. Of course, if you’re a professional, you're not going to let greed blind you. Professional traders try to avoid owning anything that has a real potential of going bankrupt. Things can occasionally go amiss, even with the best-laid plans and seemingly respectable firms, like Lehman Brothers.

Let's say you initially thought a retailer was going to pull off a turnaround and bought shares in that stock. As it turned out, the company missed on the top line and the bottom line while reducing guidance for the fiscal year. It also took on more debt to help finance existing operations. That’s an absolute disaster. There is no good news here, and the risk/reward is atrocious. A professional trader will admit defeat and move on. There is no guarantee a stop-loss will have the effect you desire due to the potential of a gap-down. It’s still highly recommended that you use one on speculative stock purchases.

The Bottom Line

When it comes to stop-loss orders, your approach should depend on whether or not you’re trading ETFs or individual stocks. With a typical ETF, a short-term plunge is the absolute worst time to have a stop-loss in place if you have the trend correct. Instead, this is where you want to step up and buy more.

There is much higher risk with an individual stock than with an ETF because there is no diversification. In this situation, a stop loss should be strongly considered, especially if it is a speculative play.

Finally, do not overtrade. In order to control your emotions and limit trading fees, avoid day trading and stick to trend trading. Don’t go to the game. Let the game come to you.