As the investment community continues to trumpet the many potential advantages of exchange-traded funds – including lowers costs, tax efficiency, and transparency, one advantage that is often overlooked is the ability to place stop-loss or sell stop-limit orders on ETFs. Because ETFs trade intra-day on the exchanges like stocks, investors can utilize tools that aren’t available with mutual funds.
A stop-loss order is simply an order placed with a broker to sell a security when it crosses below a certain price threshold. For example, if an ETF share is purchased for $25.00 and a 10% stop-loss order is immediately placed on the share, the broker will execute the sale of the share at the market price when the ETF trades at $22.50 or lower. Note that a stop-loss order doesn’t guarantee the trade will be executed at $22.50, only that the sell order will be triggered. If the price of the security is deteriorating rapidly, the sale could actually be executed at a lower price.
A sell stop-limit order is similar, except that more precise control can be exercised over the sale price. If a stop is entered at $22.50 with a limit of $22.00, the sale will be triggered once the ETF trades at $22.50 or lower, but the trade will only be executed if the broker can sell at a price of $22.00 or better. This allows the investor to ensure they receive a certain price or better for the ETF if the sale order is triggered. It’s important to note that if the price of the ETF quickly gapped down below $22.00 before the sale could be executed, then the sell order would not be filled (versus a stop-loss order where the order would be filled regardless of the price once the ETF hit $22.50 or lower).
While these types of orders are not for everybody and wouldn’t come into play for traditional buy-and-hold investors, these can be useful tools for more active approaches – particularly in the type of market we’re currently operating in. After a run-up of nearly 50% in the S&P 500 and given the still uncertain economic environment, many experts are concerned that there could be a significant pullback. While no one knows for sure what will happen, ETF investors can utilize stop-loss and sell stop-limit orders to ensure they lock-in profits and limit severe drawdowns in the event there is a sharp market decline. In contrast, with mutual funds, sales can only be executed based on the net asset value of the shares of the fund at the end of each day and also require investors to continuously monitor market events. With ETFs, investors can tend to their busy work and family schedules or go on vacation and have confidence that downside protection is in place.