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moneysense.ca, 13/05/10
Dos and Don’ts in Trading ETFs
The media is calling last week’s freak 1,000 point plunge in the Dow Jones Industrial Average a “flash crash”. The crash was especially deadly for ETFs. Media reports indicate that as much as one fourth of ETFs suffered suspicious declines. More than two-thirds of the names on the list of canceled trades involve ETFs. ETFs trading on the TSX were not immune to the crash. For instance, the iShares Dow Jones Canada Select Dividend Index Fund (XDV) traded as low as $14.30 and recovered to close at $19.15.
Most of us are investors, not professional traders and we buy ETFs with the aim of holding them for the long-term. However, we have to recognize that, unlike mutual funds, ETFs depend on markets operating smoothly to keep prices in line with NAV and markets do occasionally go haywire.
Don’ts in Trading ETFs
- A Stop Loss Order is a sell order placed below the current market price. It becomes a market order if the stock reaches the stop loss price or trades below it. If you enter a stop loss order, your experience could turn out like this one reported in the Wall Street Journal. A financial advisor with $4.2 million in three widely-held ETFs had placed sell orders on them. They were cashed out at prices ranging from 10 cents to 12 cents leaving a grand total of $4,200 in the account. Don’t let it happen to you.
- A Market Order is an order to buy or sell a specified number of shares at the best available price. For liquid and widely-held ETFs, market orders are typically filled close to the market price. But in times of extreme volatility, a sell order even for the most liquid security might attract just stink bids. It may be best to avoid this risk altogether with a Limit Order.
Dos in Trading ETFs
- A Limit Order specifies the price at which you are willing to buy or sell a security. By entering a buy order at a penny or two higher than the ask price or a sell order at a penny or two less than the bid price and the bid-ask prices are close to NAV, an ETF investor can avoid being surprised by market action like the one last week.
- If you must, at least enter a Stop Loss Limit Order, which is exactly like a Stop Loss Order, except that it becomes a limit order if the stop loss is triggered.
moneysense.ca, 13/05/10
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I don’t understand why anybody would put a stop-loss order on their equity positions like that financial “advisor” did.
Equities can go down – if you can’t handle losses then I think you should make changes to your asset allocation (ie buy more bonds) rather than adding stop-loss orders or buying insurance (put options).
This was in informative posting for me. I am new to trading stocks, “ETF’s” and haven’t grasped all the buy sell techniques or what their consequences are. A lot of financial advise is dispensed with the assumption that those taking it are aware of the “obvious” but I am here to tell you I am welcome to good advise no matter how basic it is.
John
@Four Pillars: I think it is inexcusable for an advisor to put in a stop loss order. Clients are paying them to look after their financial affairs, not plead ignorance about something as basic as stop loss orders. And then he talks about his mistake to the WSJ? That can’t be good for business.
@John: I always enter a limit order within a penny or two of the bid-ask price (as long as the bid-ask is itself within a few pennies of the NAV). I’ve done market orders in the past with stocks but kicked the habit when I learned a bit about the downsides. Never done stop loss or stop loss limit orders. Like 4P says, stocks will fluctuate and if I can’t live with that, stocks aren’t the place to be.
I don’t think stop-loss orders make much sense for long-term investors. I also don’t think that short-term thinking makes much sense for stock investing. That doesn’t leave much room for stop-loss orders.
Interesting… Most financial books do recommend to use stop-loss orders to protect your investments and cut losses. Stocks will fluctuate, but if you put e.g. 20% trailing stop loss order it won’t be filled unless some disaster happens in the market. “Flash Crash” is a bad example. Nobody still knows what happend and most trades have been cancelled anywasys…
@Erasm: Yes, many investment books do recommend stop-loss orders but I question whether an investor should be invested in a stock at all if she can’t handle a 20% drop. A stock could drop 20% for reasons that have nothing to do with the fundamentals. Maybe a large mutual fund has a new manager who decides to start over with a clean slate.
Regardless, it is not true that most trades were canceled. Let’s take VTI as an example. It was trading at a price higher than $55 for the past three months. An investor with a stop-loss order at say $44 might have sold VTI sold for $25 and their trade would stand. That’s a huge loss for what essentially turned out to be a trading glitch. I wouldn’t take that risk with long-term investments.
Re: Market Orders.
Is the risk actually that high? I know I’ve been ‘burned’ with these, but not exactly, orders were executed within 1% of my expected bid price.
I don’t know the ‘market mechanics’ behind these glitches, but maybe there is support against market orders if these types of things now have a higher probability of happening.
@Sampson: I agree that the risk of a market order not getting filled close to the last market price is very low. But in highly volatile markets, investors might get burned with a sell order that attracts only stink bids. I agree that the risk here isn’t as large as with stop-loss orders but most large brokers charge the same for a market order and a limit order, so why take the risk at all?
@CC: and the brokers that do charge different fees for market vs limit orders often charge more for the market order because of “liquidity fees”.
A stop-loss order is handy for an individual investor to protect themselves against a rapidly disseminating negative news item (e.g., a report of accounting fraud) when they know that they can’t keep minute-to-minute tabs on their investments (for instance, due to a day job). It’s another form of protection against ignorance.
However, that shouldn’t really be applicable to an ETF since you get the protection from ignorance from the diversification, and any big moves may be just market gyrations rather than changes to fundamentals…
I also don’t think that professionals should have them because it’s their job to keep up-to-date on the goings-on of their portfolio, and because they should know that their order sizes are too big for market orders (they can swing a market all on their own).
[...] Canadian Capitalist tells us the dos and don’ts in trading ETFs. [...]
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CC has exaggerated a bit with Ted Feight who presumably lost 99.9% of ETF value in his investments in a variety of Russel index funds. He did not. The obvious mistake was later corrected. If you read carefully to the end of the article you will find that next day the trades were canceled. He did lose ~10% on his Chinese ETF, however.
Nevertheless, I agree with the message. Stop loss can be detrimental in fast moving markets. It seems that stop limit orders can be safer in such instances. Some banks (such as RBC) do not even allow stop loss orders in Canadian markets.
Cheers