How To Lose Money Trading ETFs

by on July 23, 2012 | Updated May 26, 2014

ETFs have found their way into countless portfolios as investors of all walks have embraced this product structure as the preferred means of tapping into previously difficult-to-reach corners of the market. In addition to offering transparent, diversified and cost-efficient exposure to virtually any asset class, ETFs have also gained popularity with more active traders who have embraced the instruments’ ease-of-use and intraday liquidity. As with any financial instrument, however, with innovation also comes complexity; ETFs are far from foolproof despite their numerous efficiencies, requiring careful consideration and risk management when it comes time to placing your buy or sell order [see also Free Report: How  To Pick The Right ETF Every Time].

The ETF industry is similar to our ever-changing economic landscape in the sense that investors and traders alike need to stay on top of current trends and new developments as education is most certainly an ongoing process. Below we outline two ETF trading examples that highlight how carelessness and lack of experience can end up costing you serious money.

Keep An Eye On Trading Volumes

ETFs use a unique “creation/redemption” mechanism that allows for the number of shares outstanding to fluctuate based on supply and demand; this mechanism keeps the prices of ETFs in line with the value of the underlying securities. In essence, liquidity is available across all ETFs, but investors should note that it’s not necessarily guaranteed. What this means is that every ETF, even not-so-popular ones, can be traded intraday without a hitch; however, individual investors still need to exercise caution when moving in and out of positions because although liquidity is available, it is by no means guaranteed to be efficient.

Consider the chart below. The iPath Long Extended Russell 1000 Index ETN (ROLA) last traded on June 5, 2012 posting a colossal loss of nearly 30%. At first glance, it might appear that June 5 was an awfully volatile day that ended up disastrous for those who were long ROLA. However, when you consider the performance of the Russell 1000 Index it’s a different story. The Russell 1000 Index had been steadily declining since early May of 2012, and because ROLA had last traded on April 26,2012, it makes sense that buyers and sellers on June 5 had to adjust for the vast difference in performances between the ETN and the underlying benchmark. This example illustrates how investors need to be mindful of actual trading volumes despite the fact that all exchange-traded products are by nature liquid instruments.

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How To Avoid This Blunder: The ETF universe is vast, which means you likely have multiple options for achieving a specific objective at your fingertips. With several dozen leveraged equity ETPs to choose from, active traders have a laundry list of popular tools to pick from that trade each and every day, thereby removing a lot of the guesswork that can arise when trying to move in (or out) of an instrument which has sparse trading volumes [see 17 ETFs For Day Traders].

Be Wary Of Market Orders

You’ve done the analysis and the research, and you’re finally ready to buy. So how do you do it? Screwing up your trade execution is a surefire way to frustrate yourself after doing extensive fundamental research on a product. Consider the chart below and take note of the spike on July 10, 2012 when the IQ Hedge Multi-Strategy Tracker ETF (QAI) hit a high of $28.83 a share, almost 5% above its opening price that day. Notice how the price immediately corrected lower the following day. So what happened?

To make a long story short, someone got burned. This trade was a result of a market-on-close order, which is a market order that is entered into the NYSE closing auction, which falls outside of the regular trading session. The problem with market-on-close orders is that they are exempt from Rule 611, which basically protects investors faulty trades by comparing all nationally placed quotes. In other words, someone careless entered a market order that turned sour as the asking price shot up nearly 5%, which in turn burned the buyer and rewarded the seller with an easy arbitrage-like profit. Ugo Egbunike at IndexUniverse offers a very insightful, in-depth look at the mechanics behind this infamous trade [see also 3 ETF Trading Tips You Are Missing].

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How To Avoid This Blunder: Avoid market orders, simple as that. Whether you trade stocks, bonds, ETFs or commodities in the morning, lunch time or five minutes before the closing bell, it’s always prudent to use limit orders. Limit orders are instructions to your broker not to process a given trade unless the price of the ETF is at or better than the limit you define. When you use market orders, you are at the mercy of a fluctuating market price, while with limit orders you define the price you are willing to buy or sell at, giving you more complete control over your trade execution [see also 5 Questions To Ask When Buying An ETF].

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Disclosure: No positions at time of writing.