The answer to the question of whether stop-loss orders are a good idea when trading exchange-traded funds (ETFs) may seem like a simple one, 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.
ETF Stop Loss = Big Risk
This equation might seem backward at first. However, if 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 so your sale isn’t triggered at the bottom, but 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. (For more, see: Introduction to Order Types.)
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 possible 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. This means that XRT would have to move back up to its real value. This is exactly 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.
Amateur vs. Professional
If you have any association with the stock market, then you have likely come across all kinds of traders, but let’s narrow it down to just two types: amateur and professional. The amateur trader will have several screens running at once, TV pundit voices blaring in the background and his feet rested up on a mahogany desk as he puffs on a cigar and looks at you with an air of superiority. He’s the kind of guy who wears a suit despite working from home and owns a luxury car on credit.
The professional trader is much more stealth with his wealth. He trades with discipline and conviction, and without emotion. He might apply technical analysis, but he knows that in order to have true conviction in a trade, he must know the fundamentals behind that trade, which requires deep-dive research. It’s simply impossible to have real conviction in a position if only applying technical analysis. (For more, see: Traits of a Successful Trader.)
If a professional trader sees that an ETF is trading well below where it should, based on research, then he will not doubt himself and sell. Instead, he will buy more shares incrementally. When you have real conviction, you have no fear buying more shares of an ETF at predetermined intervals. Excluding leveraged 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, unless you want to wait long periods of time, you must have the trend right, which should be based on research as well as technical analysis. When both are bullish, you have the trend right.
Also, in regard to dollar-cost averaging, you might want to consider never adding to a position below your lowest buy point. This might limit upside potential to a certain degree, but it will preserve capital. Furthermore, set a capital allocation limit for each ETF and diversify long and short so 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.
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. (For more, see: How to Avoid Emotional Investing.)
Stock Stop Loss = Reduced Risk
Stop-loss orders do have value, but only for individual stocks. Unlike traditional ETFs, an individual stock has much more 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 or own anything that has real potential of going bankrupt. However, even with the best-laid plans, things can go amiss.
Let’s say you originally 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 in order to help finance existing operations. It’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. While 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 traditional ETF – as opposed to a leveraged ETF – if you have the trend correct and the ETF plunges uncharacteristically on a short-term basis, then this is the absolute worst time to have a stop loss in play. Instead, this is where you want to step up and buy more. There is much greater 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’s a speculative play. (For more, see: Redefining the Stop Loss.)