Avoid 4 Common ETF Trading Mistakes

Buyers—and sellers—beware: Trading mistakes can be costly, but they are avoidable.

As much as I love collecting charts of terrible trades, it really does break my heart to see folks clearly losing money because of simple mistakes.

My email box is sometimes full of proof that investors get burned by not paying attention to the basics. And if I had to categorize the big mistakes, I’d put them into four buckets:

1. The Accidental Stop

I’ve written about how stop-loss orders can be problematic when markets get frothy. But it’s not just a mini flash crash that can trigger a stop, it can be something as simple as a dividend.

Take a look at this chart for the iShares Global Telecom ETF (IXP | B-80):

With telecom companies on a tear this year, it’s entirely reasonable that a cautious investor might have put in a round-number stop-loss for $65 before 2014 is over. The idea would be that if the bottom fell out on what was an otherwise nice-looking chart, your $65 stop would turn into a market order, you’d liquidate your position and lock in gains.

And doesn’t it look like that was a good idea in June? Nope. IXP continues its attractive 18-percent-a year trajectory. The problem is that telecoms tend to pay big dividends, and those dividends get paid out in distributions.

In fact, IXP made a $6.37 distribution in June. Most investors see that as a good thing, but most trading systems don’t adjust your sleeping stops for distributions. As far as your stop-loss is concerned, the price dropped $6.37 in a nanosecond. And, poof!—now you’re out there screaming “sell sell sell!” whether you wanted to or not.

2. The Dumb Market Order

It’s hardly news that ETF traders—and, indeed, all traders—should generally avoid using market orders. After all, when you place a market order, you’re literally telling the market, “I just want this trade done, and I don’t care about the price.” Any time you tell someone you don’t care about the price, you’re going to get a bad one.

Still, many traders, particularly active traders, feel like market orders give them guaranteed executions, and in highly liquid ETFs, the vast majority of the time, with a market order in a liquidity giant like the SPDR S&P 500 ETF (SPY | A-98), they’re generally not going to get into trouble.

Until they do.

Here’s a chart of trading in one of the largest, most liquid ETFs on the planet: the SPDR Gold ETF (GLD | A-100):

This was on an otherwise-uneventful day back in January, but these kinds of mini-flash-crashes happen in all sorts of ETFs all the time. It’s important to recognize that hiccups like this aren’t errors. In this case, GLD dropped a few percentage points and recovered in two minutes because of a large trade on the futures market, which spooked gold prices.

Imagine being the poor guy who put in his market order to sell GLD that morning as it was crossing $120—only to find out he got executed at $118. We all like to think we’re paying attention when we trade, but markets move fast. Very fast. Market orders leave you exposed to every speed bump and hiccup, whether you want to be or not. That just adds risk.

3. Walking Into Barn-Door Spreads

A lot of ETF investors develop brand loyalty. I’ve run into countless advisors who say they’re “a Vanguard investor” or “only use iShares” and the like. The main reason for that brand loyalty is consistency. Novice ETF investors are often nervous about making a bad choice and getting burned, and it seems like just sticking with the biggest players would be a good safety blanket.

Unfortunately, even at the biggest companies, you can’t get away from market reality. Some ETFs are just small, and don’t trade that well.

Consider the iShares MSCI Emerging Markets Value ETF (EVAL | D-94).

I really like this fund—it takes the broad emerging markets index from MSCI and just buys the cheap stocks. It’s a cool idea. The problem is the fund—despite having almost $25 million in assets—trades worse than you might expect. On most days, only a few thousand shares change hands.

Consequently, the spreads on EVAL are so wide you could drive a tanker truck through them. Here’s the bid/ask for the past few weeks, with the heavy purple line showing actual trades:

So what does this mean to you?

Well, you can see that, quite often, the blue-line trades are inside the spread. That happens either when someone calls a trading partner and says, “You’ve got to be able to do better than this!” or a smart trader puts a limit order inside the spread, and the market comes to them briefly.

In other words, you can get a trade done here, you just need to be careful.

But you see all those trades happening right in line with the “Ask?” Those are people who are either putting in market orders, or who don’t get that the judicious use of limit orders can often walk these spreads in to a more reasonable level.

4. Trading On The Wrong Side Of The Flow

We talk a lot about ETF fund flows here at ETF.com. Most of the time, I’m skeptical about their importance as an indicator that you can trade on. But there’s one thing you absolutely can bet on with fund flows: If you’re the guy buying and selling with the herd in a small ETF, you can get burned.

Consider the Global X Uranium ETF (URA | C-94). This is a solid fund providing unique exposure to uranium miners. Unlike EVAL, URA actually trades reasonably well. Hundreds of thousands of shares change hands daily at 3-cent spreads.

So what’s the problem? URA tends to respond very strongly to supply and demand for shares, leading to flow-dependent premiums and discounts:

Charts courtesy of Bloomberg

This chart from Bloomberg’s “NAV” (net asset value) function shows the premium for URA on the top, and the flows for URA on the bottom. Flows in this display are usually lagged by a day. Notice that big swing from a 0.49 percent premium on July 7 to a 1.18 percent discount on July 9? It’s driven entirely by fund flows. That’s a nearly 2 percent swing that had nothing to do with whether URA was going up or down.

These kinds of premiums and discounts can be enormously difficult to predict, and can happen even in big funds if their underlying market is less liquid—something we see in high-yield bonds all the time, for instance. In this case, URA holds just 23 companies, most of them outside the United States, and almost half of them micro-caps.

So, as an investor, what do you do?

It may sound like motherhood and apple pie, but “buy low and sell high.” Avoid buying at steep premiums, and try and hold off on the panic selling if the ETF is showing a deep discount. Most of the time, these conditions resolve themselves fairly quickly—within a day or two.

Don’t Be That Guy

That’s four easy mistakes, easily avoided.

But really, they all come down to the same things: Get informed and pay attention. Taking control of your trading is a surefire way to minimize the risks in your ETF strategy, and avoid ending up as another example in my inbox.

At the time this article was written, the author held no positions in the securities mentioned. Contact Dave Nadig at [email protected].