Are Stop-Loss Orders and ETFs a Good Idea?

Stop-loss orders are used by many stock investors as a way to limit their potential losses. But are they an equally good idea when trading exchange-traded funds (ETFs)?

The answer is usually no. A sharp drop in an ETF's value is most likely a short-lived response to immediate market conditions. A stop-loss order on an exchange-traded fund can just lock in your losses.

Why Is a Stop-Loss on an ETF Risky?

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, even briefly, hits a low price.

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 requires liquidity, speed, and plenty of cash.

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, you would know something was amiss. It’s simply not likely that all the stocks in the S&P Retail Select Industry Index will drop 10% or more at the same time regardless of economic and market conditions.

It's more likely that it's due to an error in a bearish and illiquid environment. That means XRT will probably move back up to its real value soon.

This is precisely where you would want to buy more shares, not sell. Unfortunately, if you're using a stop-loss, you're going to have no choice but to sell.

Many people were locked in losses with such stop-loss orders during the flash crash on May 6, 2010.

What Do the Trading Pros Do?

If you have any association with the stock market, 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.

The professional trader trades with discipline and conviction and without emotion. A professional might apply technical analysis but knows that deep research into fundamentals is also necessary. Self-discipline and the ability to manage risk through statistical analysis are the primary traits of a successful trader.

A professional trader who concludes that an ETF is trading well below where it should, based on solid 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.

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.

How Stop-Loss Orders Work in Stocks

Stop-loss orders have value 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 go wrong, even with 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. The next quarter, the company misses on the top line and the bottom line while reducing guidance for the fiscal year. It also takes 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 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, assuming you read the trend correctly. 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.