ETFs: How Do You Trade This Uncommon Instrument?
An exchange-traded fund or ETF is a financial instrument that allows you to diversify your portfolio by investing in a basket of assets. ETFs are quite liquid and imply low fees. That’s why they attract investors and traders worldwide.
However, to pick out the right fund, you need to consider many factors that not only determine a good ETF but also affect the price movements of the underlying assets. Read this article to learn all the aspects you should consider before you buy your first ETF.
What Is an ETF?
An ETF or exchange-traded fund is a financial instrument that resembles a mutual fund. ETFs are traded on a stock exchange the same way shares are. It is the major difference between an exchange-traded fund and a mutual fund. ETFs can track various asset classes, including currencies, commodities, bonds, and stocks or a basket of assets. There are specific ETFs that even track an investment strategy.
ETFs are traded within a day, so their price changes during the trading day. Therefore, their volatility is high. At the same time, mutual funds are traded once a day after the markets are closed. However, higher volatility is compensated by higher liquidity. Moreover, ETFs attract investors, as they offer lower fees and expense ratios than individual stocks or mutual funds.
ETFs are widely used to diversify an investment portfolio. An ETF can track a mixture of types of investments, such as bonds, stocks, and commodities. Even if the ETF tracks only one asset type, it can include assets from various industries. Moreover, there are funds that own offerings of only one country, while others combine assets across the industry worldwide. Thus, ETFs represent a broad market.
Most ETFs are open-end funds, meaning that there are no limits on the number of investors involved in the product.
Understanding ETFs Trading: Basics
The exchange-traded fund is not a simple instrument. Stocks or currencies are more obvious. Thus, it’s not enough to read only one definition to start investing in ETFs. Let’s consider key characteristics of ETFs that will help you understand the idea behind them.
Passive or Active
ETFs can be passive and active. A passive ETF (so-called index fund) is created to track and copy the performance of a certain index’s intraday trading. Its purpose is to match the performance of the underlying index. The ETF depends entirely on the movement of the underlying asset.
An active ETF aims not to match the underlying asset but to beat its performance. Market indices serve as benchmarks when trading active ETFs. Fund managers of active ETFs try to get higher returns, outperforming the underlying index.
An expense ratio (or so-called management expense ratio) is used to evaluate the amount of assets of a certain fund that are used for operating expenses. To calculate the ratio, you need to divide a fund’s operating expenses by the average value of its assets under management (AUM) in dollars.
Before investing in an ETF, you should know the expense ratio. Operating expenses shorten investors’ returns, as they affect the fund’s assets. If you know the ratio, you understand how much your potential returns will be reduced and how much you will pay in costs when investing in a certain fund. You should choose funds with a lower expense ratio.
Dividends and Dividend Reinvestment Plan
ETFs attract investors not only because they are low-cost, liquid instruments but also because many of them pay dividends. Dividends can be paid in cash or reinvested via a dividend reinvestment plan.
Main Types of ETFs
ETFs track not only assets but also industries, sectors, and even investment strategies. Let’s consider the key types of exchange-traded funds.
Stock ETFs include numerous stocks. They are used to track an industry or sector. Investors prefer stock ETFs because they allow them to diversify their portfolios. When trading stock ETFs, you don’t own actual shares.
Also, there are many stock index ETFs that track an equity index. If you are not a newbie, you know that there are many stock indices, which include stocks of companies that match certain conditions. Indices reflect the situation in certain sectors, industries, or even states.
Bonds are stable financial instruments. They don’t provide enormous income. However, they attract investors with their stability. A bond ETF’s income depends on the performance of the bond the fund tracks. An ETF can contain government, corporate, and municipal bonds. Bonds have a maturity date, but ETFs don’t. Bond funds are traded at a premium or discount from the bond price.
ETFs are widely used to track a certain industry or sector. When trading such an ETF, you can track the performance of the whole industry/sector. ETFs usually include stocks of the leading companies. As a result, the performance of each of the included shares will reflect the health of the overall industry or sector.
Unlike real stocks, ETFs are less volatile, as the price fluctuations are smoothed, and investors don’t own real shares.
Commodity ETFs are used to track the direction of a certain commodity, including gold, silver, and crude oil. It’s cheaper to purchase a share in a commodity ETF than own a real commodity. To hold a physical commodity, you need to insure it and find a special storage place — for example, a deposit box for gold or silver.
Commodities are negatively correlated with most assets. Therefore, they can be used to hedge your funds and diversify your portfolio. For instance, gold and silver are safe-haven assets, while stocks are risky assets. It results in the appreciation of gold or silver ETFs in periods of market uncertainty and the depreciation of stock ETFs.
There are commodity and commodity-linked ETFs. While commodity ETFs track the price of the underlying commodity, commodity-linked ones follow companies within a certain industry.
Commodity ETFs rarely comprise a physical commodity. Their price is based on futures contracts.
Currency ETFs can reflect the price direction of a currency or basket of currencies. Such ETFs are used to speculate on the currency price considering state political and economic events. Thus, you can trade on the economic or political conditions of the particular region. Currency funds can also help you diversify your portfolio. Some exchange-traded funds are bought to hedge against foreign asset risks or volatility.
Geographic ETFs are used to follow assets of a certain region. If you want to get exposure across American companies, you can buy a US ETF. When you are interested in European indices, you can buy a European ETF.
Inverse (Short) ETFs
Inverse ETFs can use any underlying asset. Such funds sell the underlying asset expecting it to decline soon. However, they don’t stop here. They buy the underlying asset back when the price reaches significant lows.
Inverse exchange-traded funds use derivatives to sell the asset. When the underlying asset declines in value, the ETF rises by a proportionate amount.
You should know that many inverse ETFs are not real ETFs but ETNs (exchange-traded notes). A note is a bond that is traded like a stock and is backed by an issuer, including banks.
Leveraged ETFs track a certain asset and use derivatives (futures or options) to multiply the return of the underlying investments. For instance, your fund tracks the S&P 500 Index: when the Index increases by 1%, the leveraged ETF will return 2%.
It sounds attractive before you understand that losses are multiplied as well. It means that any fall of the Index by 1% will result in the ETF’s loss of 2%.
- As exchange-traded funds cover a wide range of markets, it may be difficult to define top funds. First, choose the underlying asset that the ETF will follow. If you are interested in commodities, you can find funds that track gold or stocks of gold mining companies, for example.
- Second, determine the size of the ETF. To evaluate the ETF’s size, you should consider the assets under management (AUM) parameter. AUM reflects the total value of held investments. Larger funds often have better liquidity than smaller ones, which means they have lower trading spreads – saving you money in the long run, as you can open your position for less.
- Third, you should consider the major characteristics of the fund we mentioned above, including expense ratio, dividends, and whether it is a passively or actively managed fund.
Here is the list of the top funds that provide broad market exposure. A newbie trader can consider them to start trading ETFs.
- Schwab U.S. TIPS ETF (SCHP). This fund is the easiest way to access an unknown market of treasury inflation-protected securities (TIPS). TIPS are used to protect investors against inflation.
- Schwab U.S. Dividend Equity ETF (SCHD). The ETF replicates the Dow Jones U.S. Dividend 100 Index. The expense ratio is 0.06%.
- Vanguard Total International Stock ETF (VXUS). It’s a passive international fund, using the FTSE Global All Cap ex US Index as the underlying asset. The Index tries to copy the performance of companies that operate in developed and emerging markets.
- Vanguard Tax-Exempt Bond ETF (VTEB). The passive fund follows the investment-grade segment of the American municipal fixed income market. If you remember, we said that the fund should have a low expense ratio to limit investors’ costs. VTEB has a 0.06% expense ratio.
- Vanguard Total Stock Market ETF (VTI). The exchange-traded fund copies the direction of the American equity market composition. The underlying asset includes all mega-cap enterprises. Its expense ratio is much lower than the average ratio of similar funds — 0.03%.
- Vanguard Small-Cap Value ETF (VBR). The passive ETF uses its benchmark, the CRSP US Small-Cap Value Index, providing access to small-cap value shares. The expense ratio of 0.07% is smaller than that of most similar funds.
- Vanguard Real Estate ETF (VNQ). The passive fund replicates the MSCI US Investable Market Real Estate 25/50 Index. Although the average expense ratio of similar funds is 1.08%, VNQ’s ratio is 0.12%.
- Vanguard Dividend Appreciation ETF (VIG). The passive exchange-traded fund uses S&P US Dividend Growers Index as its benchmark. The Index consists of American companies that have been raising their dividends for at least ten years. The average expense ratio of similar funds is 0.81%, while the VIG has a ratio of only 0.06%.
- ProShares UltraPro Short QQQ ETF (SQQQ). It’s an inverse leveraged fund that tracks the Nasdaq 100 Index. The fund multiples the daily decline of the Nasdaq 100 Index by three. The fund is attractive for the short term. In the long run, it can bear high risks of losing money that will be multiplied if the Index moves up.
- iShares Core US Aggregate Bond ETF (AGG). The AGG fund is considered the largest fixed-income exchange-traded fund worldwide. The expense ratio of 0.04% is one of the lowest to get exposure to the bond market.
How To Start Trading ETFs
To purchase a share in an ETF or trade the ETF via derivatives, you should take the following steps.
Step 1. Decide How To Deal with ETFs: Trading vs. Investing
As the ETF is quite a popular financial instrument, you can both invest in it and trade it. It’s up to you what option suits you the most.
Investing allows you to purchase a fund’s share and own the asset. As most ETFs pay dividends, you can be granted certain payments. If you manage to sell your share for a higher price than you purchased it, you will gain additional rewards.
Trading doesn’t allow you to own the underlying asset. You speculate on the price of derivatives products, opening long and short positions. The derivative products, like spread bets and CFDs, track the price of the underlying asset of the ETF you choose. When trading, you can open a margin account that allows you to use leverage and start trading with a limited initial deposit.
Step 2. Choose a Broker and Open a Retail Investor Account
It’s vital to choose a reliable brokerage firm that may protect you from increased market volatility.
For example, the NAGA trading platform offers top ETFs, including Vanguard TSM, Nasdaq Biotech, and SPDR DJIA. NAGA offers low fees and tight spreads on all assets. You can trade from the mobile and web applications or use MetaTrader 4 or 5.
Opening a brokerage account is free of charge and takes only a few minutes. The platform could protect you from unexpected losses and offers a demo account, so you can try a new financial instrument or test your trading strategy.
Step 3. Develop a Trading Strategy
ETF is an uncommon financial instrument. Although you can trade it as a stock, commodity, or currency, it requires special trading strategies.
You are recommended to combine fundamental and technical analysis. When trading an ETF, you can use standard technical indicators and look for top charts and candlestick patterns. However, when you apply fundamental analysis, you should consider factors that affect the underlying asset of the fund you trade.
Step 4. Open Your First Trade
It’s time to open your first trade. You can place market and limit orders. With a market order, your trade will be executed immediately at the best market price. If you don’t see a good entry point now, you can place a limit order that will be executed as soon as the price reaches the level you determine. Please remember that if the price doesn’t touch the determined level, the trade won’t be opened.
Don’t forget about stop-loss and take-profit orders that will automatically close your position. A take-profit order is used to exit the market with a profit if your forecast is correct. A stop-loss order closes your losing trade if your prediction is wrong.
If you feel uncertain, you can copy the trades of experienced traders using our ultimate tool, NAGA Autocopy.
Final Thoughts on How To Trade ETFs
The ETF is a complex instrument. Although you can trade it as a currency or commodity, you should have comprehensive product information, including numerous factors and characteristics that determine a fund’s value. Aside from the factors that affect the price of the underlying assets, you should consider the fund’s size, type, structure, and expense ratio.
To succeed in ETF trading, you should find a reliable broker. The NAGA platform is ready to offer you the best trading conditions, with over 950 assets, professional trading tools, free trading signals, and market news. NAGA Markets Europe Ltd is a regulated and licensed broker in the European Union, while NAGA Global LLC covers the rest of the countries around the globe.