By Randy Frederick, Vice President of Trading and Derivatives, Charles Schwab.

Randy Frederick, Vice President of Trading and Derivatives, Charles Schwab.

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, 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 US exchange-traded products closed in 2017 – 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.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)