What Are ETFs & ETF Trading?
Exchange Traded Funds (ETFs) are investment funds that hold assets such as bonds, tocks, foreign currency, or even stocks. ETFs often track indexes such as the Dow Jones, Nasdaq, the Russel 2000, and the S&P 500.
Investing in ETFs does not mean directly owning the underlying investments, but rather means that you have an indirect claim and are entitled to some of the profits as well as residual value in case of liquidation of the fund.
Types of ETFs
Exchange Traded Funds (ETFs) are of many different types. Some of the most common types of ETFs include:
Index ETFs mimic specific indices such as the S&P 500 Index and typically cover specific sectors, specific stock classes, or emerging or foreign market equities.
Stock ETFs hold a portfolio of stocks or equities and are similar to indices. You can treat them like regular stocks since you can buy and sell them at a profit and they are traded on exchanges throughout a trading day.
Bond ETFs are specifically invested in fixed-income securities such as bonds. This type of ETF may be focused on a specific ty pe of bond or offer a widely diversified portfolio of varying maturity dates and of different types.
Currency ETFs are invested either in a single currency or multiple currencies and are widely popular among investors looking to gain exposure to the forex market without trading directly in the forex or futures market. Currency ETFs typically track the most popular international currencies, such as the British Pound, United States Dollar, Euro, Canadian Dollar, and the Japanese Yen.
Commodity ETFs hold physical commodities such as precious metals, natural resources, or agricultural products. Some commodity ETFs may hold a combination of investments in a physical commodity as well as related equity investments. For instance, a gold ETFs may have a portfolio that combines holding stock shares in gold mining companies with physical gold.
Leveraged ETFs mostly comprise of financial derivatives that offer you the ability to leverage investments thus potentially increasing gains. This type of ETFs is primarily used by traders who are looking to take advantage of short-term trading opportunities in the major stock indexes.
Actively Managed ETFs
Actively managed ETFs are handled by an investment team or a manager who is responsible for deciding the allocation of portfolio assets. Since they are actively managed, they typically have higher portfolio turnover rates.
Real Estate ETFs
Real estate ETFs are invested in real estate development companies, real estate service firms, real estate investment trusts (REITs), and mortgage-backed securities. Thy may even hold physical real estate, including anything from large commercial properties to undeveloped land.
Inverse ETFs are created using multiple derivatives to gain profits via short selling when there’s a decline in the value of a broad market index or a group of securities.
How Do ETFs Work?
ETFs are bought and sold just like regular company stocks during the day when the stock exchanges are open. Just like stocks, ETFs have ticker symbols and you can easily obtain the intraday price data during the course of your trading day.
Unlike regular stocks, the number of shares outstanding of ETFs may change on a daily basis due to the redemption of the existing shares and the creation of new shares. The ability of ETFs to redeem and issue shares on a continuous basis helps keep the market price of the ETFs in line with the underlying securities.
ETFs are primarily designed for individual investors, but institutional investors play an important role in maintaining their liquidity and tracking their integrity through the purchase and sale of creation units, which are massive blocks of ETF shares that you can exchange for baskets of the underlying assets.
If the price of an ETF deviates from the value of the underlying asset, institutional investors take advantage of the arbitrage mechanism afforded by the creation units to help restore the price of the ETF back in line with the value of the underlying asset.
What is ETF Trading?
ETF trading works exactly like stock trading as previously stated. ETFs bring together some of the best features provided by stocks and mutual funds. ETFs track benchmark indices and trade on exchanges in shares like stocks.
ETFs provide a cheaper alternative to get exposure un a sector that’s otherwise very challenging to trade.
For instance, say you want to invest in gold. You have several options available to you, such as buying physical gold coins or gold bullion bars or trade gold futures contracts. However, these are time consuming, difficult, risky, and expensive ways to invest in gold. The cheaper, better, and less time-consuming option available to you is to buy shares of a gold ETF that follows the market price of gold. You can do all that with much less effort and at a fraction of the cost.
If you believe that the whole stock market will go up in value, you can invest in a stock index such as the Dow Jones. You can choose either to buy all the 30 companies that make up the Dow Jones Index or you can buy DJIA futures contracts, which are both very expensive options. If you want to achieve similar results at a fraction of the cost, you can buy shares of an ETF that follows the Dow Jones.
How to Start ETF Trading
If you want to get started with ETF trading, you need to follow the steps outlined below:
1. Open a Brokerage Account
If you want to trade ETFs, it is important to first have a brokerage account. ETFs trade like traditional stocks, with their shares available during trading hours for major stock market exchanges. The broker you choose can translate to added benefits.
For example, brokers that offer their own ETFs allow you to trade their proprietary ETFs without having to pay commission. Other brokers have partnership agreements with third-party ETFs providers under which they don’t charge commission on ETF trades.
2. Focus on:
You need to focus on the following when trading ETFs:
Fees and Commissions: ETFs are typically traded by commission. However, they are generally more cost-efficient than actively managed mutual funds due to their indexed nature, which usually results in lower fees.
Diversity: Investors typically find ETFs a great option for getting involved in markets that they might not otherwise trade or invest in. Since they are baskets of assets as opposed to individual stocks, ETFs allow for more diverse investing, which helps mitigate risks for most investors.
Choice: You have a wide variety of ETFs that you can choose from across different assets classes, such as bonds and stocks. You can even choose by commodity, sector, geographic area, investment style, etc. Better yet, many ETFs are continually introduced with an interesting combination of holdings.
Liquidity: The ETF market is massive and active with popular, heavily traded issues, which makes it easier to get in and out of trades. However, liquidity varies significantly and some narrowly focused ETFs are usually illiquid.
3. Create a Diversified Portfolio
ETFs typically hold similar investments, which means that owning more does not always imply having a diversified portfolio. It is advisable to look for ETFs in different asset classes, such as real estate, bonds, stocks, real estate, etc. You should also consider broadening your exposure within each asset class to balance out your portfolio’s risk.
4. Develop a Trading Strategy
You need to develop a strategy that works and stick to it. You can use either fundamental or technical analysis to develop your strategy.
Technical analysis focuses on statistics generated by market activity, such as volume, price, or other variables. Technical analysis involves the use of charting software and other similar technologies. Fundamental analysis focuses on measuring the value of an investment based on financial and economic data. Most Traders use a combination of both technical and fundamental analysis.
The strategy that you choose will depend on the holdings and focus of each individual ETF. For instance, a credit bond ETF depends on fundamental research, such as the future and past earnings of the company, its credit rating, and the economic outlook of the entire industry. In contrast, an ETF that tracks a stock index will require a strategy built on technical data of that index.
5. Build Your Skills
You need to continually develop the skills you need to potentially profit from ETF trading and investing whether you are new to it or are an experienced trader/investor. You can find numerous resources online that cater to both beginner and experienced traders to help build your knowledge and ETF trading skills.
The Bottom Line
Exchange Traded Funds (ETFs) offer a great deal of liquidity, versatility, and low trading costs, which is largely the reason why they are growing increasingly popular. If you want to be successful with your ETF trading/investing, you need to explore large, varied ETF offerings and consider making ETFs a mainstay of your overall trading/investment portfolio.