Download the Schwab app from iTunes®Get the AppClose

Trading ETFs: A Way to Manage Risk?

Have you ever spent hours identifying a potential trade, only to see the stock drop on unexpected company news, be it a sudden CEO departure, a product recall or a public inquiry? For traders who have a hard time stomaching such uncertainty, exchange-traded funds (ETFs) may be able to help.

Why ETFs?

First, like stocks, ETFs can be bought and sold throughout the trading day. Indeed, some ETFs are traded just as heavily as individual equities, so you can move in and out of them with relative ease.

Second, because ETFs track a basket of securities, the individual performance of a single holding is less likely to impact the outcome of your trade. If one stock in the fund plunges but the others hold their ground, for example, the net effect  may be only a marginal decline. Measure the historical volatility of any individual broad-market ETF against virtually any individual stock and the ETF will almost invariably be less volatile.

Third, your worst-case scenario with stocks is a total loss should the price fall to zero. With ETFs, on the other hand, it’s almost inconceivable that all of its stocks would go to zero. And in those unlikely instances when an ETF provider decides to shut down a fund—only 138 of more than 2,000 U.S. exchange-traded products closed in 20171—its investors would still get the market value of their investments once the fund’s assets have been liquidated.

ETFs are still subject to market risk, or the risk of losses when the broader market is weak. In general, ETFs are just as volatile as the indexes they track, so one that tracks the S&P 500®, for example, will generally mirror that index’s performance.

Unique risks

Traders in ETFs will want to pay particular attention to the bid/ask spread, or the difference between the highest price that a buyer is willing to pay and the lowest price that a seller is willing to accept. Due to the way ETFs are priced, their bid/ask spreads can sometimes be wide—especially for those that trade infrequently or track niche segments of the market in which the underlying assets are illiquid.

For example, if you place a market order to buy or sell immediately at the current market price, the wider the bid/ask spread, the higher the potential price you’ll pay or the lower potential price you’ll receive. For this reason, Schwab generally advises traders not to use market orders for ETFs that trade infrequently. Using a simple limit order, in which you set the price you want to pay or be paid, will help offset any discrepancies in an ETF’s price.

Traders should also be wary of leveraged and inverse ETFs, which attempt to use debt and derivatives to multiply the returns of their underlying assets. Leveraged and inverse ETFs with “2x” or “3x” in their titles, for instance, seek to return twice or thrice the daily return or daily inverse return of the underlying holdings.

However, these funds also have the potential to incur significant losses, which can be magnified to the same degree as their potential gains. Therefore, if you’re trading ETFs in part to help manage your risk, trading leveraged or inverse ETFs can be a big step in the wrong direction.

Finally, ETFs are sometimes confused with exchange-traded notes (ETNs), which are debt instruments backed only by the creditworthiness of the issuer, rather than a basket of securities, and as such involve both less diversification and greater credit risk.

Building confidence

Trading ETFs requires a slightly different practice than trading individual equities but can be a rewarding way to get your sea legs, help manage your volatility and potentially build some early successes until you’re ready to increase your risk-taking. They can also be a great fallback for seasoned traders when a stock’s price swings become too unsettling. Just as with stocks, however, you’ll want to have a plan—and stick with it. Specifically:

  • Know your investing time horizon: Determine ahead of time how long you plan to hold a given ETF.
  • Minimize your exposure: Most traders should risk no more than 2% to 3% of their account on a single trade.
  • Know where the exits are: Set profit and loss targets for each trade and consider using stop orders during market hours to help lock them in.
  • Review your performance: For instance, if you got stopped out too early, you may need to set wider price parameters or find an ETF with lower volatility. Conversely, if the ETF didn’t move all that much, you might want to find one with greater volatility. Keep in mind that both of these changes will also increase your overall risk.

 

With a few tweaks in your trading regimen, you should be able to find an ETF that aligns with your risk appetite.

1ETF.com. Total number of ETFs as of 04/13/2017 and total closures as of 12/22/2017. | All ETFs are subject to management fees and expenses. Please see the Charles Schwab pricing guide for additional information.

What You Can Do Next

Ready to start trading at Schwab? See what makes Schwab different.

Sector Shake-Up: What Investors Need to Know Now
When to Sell an Investment

Important Disclosures:

Investment returns and principal value will fluctuate and are subject to market volatility, so that an investor’s shares, when redeemed or sold, may be worth more or less than their original cost. Unlike mutual funds, shares of ETFs are not individually redeemable directly with the ETF. Shares of ETFs are bought and sold at market price, which may be higher or lower than the net asset value (NAV).

Leveraged ETFs seek to provide a multiple of the investment returns of a given index or benchmark on a daily basis. Inverse ETFs seek to provide the opposite of the investment returns, also daily, of a given index or benchmark, either in whole or by multiples. Due to the effects of compounding, aggressive techniques, and possible correlation errors, leveraged and inverse ETFs may experience greater losses than one would ordinarily expect. Compounding can also cause a widening differential between the performances of an ETF and its underlying index or benchmark, so that returns over periods longer than one day can differ in amount and direction from the target return of the same period. Consequently, these ETFs may experience losses even in situations where the underlying index or benchmark has performed as hoped. Aggressive investment techniques such as futures, forward contracts, swap agreements, derivatives and options can increase ETF volatility and decrease performance. Investors holding these ETFs should therefore monitor their positions as frequently as daily.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

(1019-9MAR)

Thumbs up / down votes are submitted voluntarily by readers and are not meant to suggest the future performance or suitability of any account type, product or service for any particular reader and may not be representative of the experience of other readers. When displayed, thumbs up / down vote counts represent whether people found the content helpful or not helpful and are not intended as a testimonial. Any written feedback or comments collected on this page will not be published. Charles Schwab & Co., Inc. may in its sole discretion re-set the vote count to zero, remove votes appearing to be generated by robots or scripts, or remove the modules used to collect feedback and votes.