Risks and rewards of trading ETFs

ETFs have some unique benefits over stocks. Here are some of the pros to trading ETFs as an alternative to trading individual stocks.

Safety through diversification

Do you ever wonder if you are going to wake up in the morning and find out your stock dropped 50% because the CEO was caught with his hands in the cookie jar? For the most part, this is not an issue with ETFs because they typically hold multiple equities and usually have minimal exposure to any one individual stock.

Consider, for example, the PowerShares Dynamic Semiconductors Fund (), the composition of which is shown in the table below. As of December 2017, a total of 30 stocks represented the underlying portfolio of PSI. Of those, the largest percentage weighting of any individual stock was only 5.51%. Even if that company, Littelfuse Inc. (), had bad news that caused its stock to plummet overnight, the net effect on the price of the ETF would be minimal. By trading ETFs, you are automatically reducing your risk of damaging losses from overnight gaps (sessions in which the opening price of an ETF significantly varies from the previous day's closing price).

That said, the ETF universe is vast and there are some ETFs that hold a small number of stocks and, as such, are more sensitive to the movements of individual stocks. Investors should be aware of an ETF's holdings before committing to a position.

Access to more markets

Through exchange-traded funds, retail investors and traders now have access to markets that were previously difficult and expensive to participate in. Treasury bonds, international markets, commodities, and even currency ETFs can all be traded with the same ease and low commission of an individual stock. With new ETFs constantly being created, the realm of trading opportunities is boundless.

Liquidity issue

Thinly traded stocks often have fairly wide bid/ask spreads. While thinly traded ETFs have a wider bid/ask spread than more liquid ETFs, the structure of ETF pricing tends to keep the bid/ask spread tighter than with individual stocks. Even if a low-volume ETF had no buyers or sellers for several hours, the bid and ask prices would continue to move in correlation with the fair market value that is derived from the prices of the underlying stocks. Because all ETFs are linked to an index, and the intraday fair market value moves in line with the underlying index, specialists can easily provide continuous pricing. If a large institutional buy or sell order suddenly arrived on an ETF with low average daily volume, the price would not jump, as it would with an illiquid stock.

Unlike stocks, ETFs are not traded on an auction system. Instead, demand is automatically met through computerized algorithms that allow specialists to create and redeem shares in an ETF at its net asset value (NAV). This is done in large blocks of shares that represent creation or redemption baskets. Once created, these new shares can then be traded in the secondary market.

Table 1: Composition of PowerShares Dynamic Semiconductors Fund (PSI)

Yes, an ETF with a low average daily volume may sometimes have slightly wider spreads between the bid and ask prices than an ETF with a high average daily volume, but you can simply use limit orders (a specified maximum price you are willing to pay for the position) instead of market orders if this is the case. Moreover, if you're trading for multiple points, paying a few cents more on occasion should not be a big deal.

Lower trading commissions

Prior to the inception of ETFs, traders were forced to pay a separate commission for each individual stock if they wanted to buy a basket of stocks within a particular industry sector. However, through trading in sector-specific ETFs, traders pay only one commission to buy or sell short an entire group of stocks within an industry.

Better odds of follow-through

Has this ever happened to you? You have identified a particular sector you would like to be in, you place the trade to buy a stock, and then you watch every single stock in that industry move higher except the one you are in. With ETFs, you are at less risk of buying or selling short the wrong stock because you are participating in an entire group of stocks within a sector. If you buy the iShares Nasdaq Biotechnology Index Fund (), it does not matter much if Morgan Stanley has a big sell order on Amgen stock, because you also have exposure to many other stocks within the Biotechnology Index.

However, there are risks to trading any instrument. Every successful trader has lost money in the market at one time or another. Realize that a certain level of risk is required in order to profit in the markets. Without taking a certain degree of controlled risk, it's impossible to earn a single dollar of profit. Taking risk, however, also means occasionally incurring substantial losses. You must accept that losing trades are a completely normal, inevitable part of the business, and you simply can't be afraid to suffer losses at times. The trick is to determine the exact dollar amount of capital you're willing to risk on each and every trade and then maintain the discipline to cut the losses when you reach your protective stops. Consistent profitability is possible with just a 50% batting average of winning trades—if the average dollar loss of each trade is less than the average dollar gain of each winning trade.

Because virtually all traders make numerous mistakes in the formative years, it’s also imperative that you substantially limit the total amount of capital risk you take until you develop a consistent track record of profitability. Trading with too heavy of a position size and trying to hit home runs before you establish long-term profitability can easily result in a loss of capital so damaging that it is impossible to recover the losses. Unfortunately, traders frequently run out of trading capital just as they're finally turning the corner and starting to "see the light." If you're new to the business, don't let this happen to you. Making small bets and swinging for just singles and doubles in the early years will ensure that you can withstand losing periods long enough to enjoy the fruits of your labor when you eventually become consistently profitable.

When it comes to capital losses, one thing that separates long-term winners from perennial losers is that winners learn from their mistakes and make every effort not to repeat them. To ensure that you remember and don’t repeat your mistakes, keep some type of trading journal to record honest observations in periods of both successful and unsuccessful trading. In your journal, you also want to maintain detailed trading statistics that will enable you to glean valuable insights. Performance measured is performance gained. Your journal can be as simple or as fancy as you desire, but the point is to get one and use it.