Hitch a Ride to the ETF Galaxy

Know about the most popular exchange-traded fund categories you are likely to come across so you can do your top-down analysis before deciding which ETFs to trade.

https://tickertapecdn.tdameritrade.com/assets/images/pages/md/galaxy map with red push pins of ETF categories: Hitch a Ride to the ETF Galaxy
5 min read
Photo by Dan Saelinger

Key Takeaways

  • Explore the five main exchange-traded fund (ETF) categories
  • Know the basics of index ETFs, sector ETFs, bond ETFs, commodity-based ETFs/ETNs, and leveraged/inverse exchange-traded products
  • Understand how to apply pairs trading strategies to ETFs

In one of the largest theme parks in the world, you can hop on and off a gondola and visit different resorts within the park. It’s a great way to get a feel for each one and perhaps narrow your resort choices for your next vacation.

You can screen exchange-traded funds (ETFs) the same way. With a boatload of them—more than 1,800 ETFs in the market today, and many added each year—how do you get a lay of the land and decide which ones to trade?

First, think about why you might want to trade them. ETFs are like mutual funds in that they contain a basket of assets, but unlike mutual funds, they can be traded throughout the day just like stocks. Consider three main reasons many investors trade ETFs:

  • Diversification. Instead of trading a single stock or commodity, you can spread out your risk by trading an ETF because they contain a group of assets.
  • Tapping alternatives. Access markets you might not feel comfortable directly trading otherwise. You can trade ETFs that track bonds, commodities, or currencies.
  • Optionable. With an appropriately approved account, you can trade options on more than 500 ETFs. They’re American style, settle for the underlying shares, and expire on Fridays.

The downside? At times, the market value of an ETF will deviate from the value of the assets of the underlying index that it tracks. They also tend to have lower volatility compared to individual stocks, and some ETFs have very low liquidity.

Let’s take a ride through the ETF galaxy and get familiar with some of the categories.

1. Index ETFs

  • Underlying is based on an index.
  • Tend to be more liquid.
  • There are many to choose from.

Game plan: Consider filtering for the most liquid index ETFs, check out their holdings, and then see how they’re weighted. There are different types of indices tracked by ETFs such as the S&P 500 Index (SPX), Nasdaq Composite (COMP:GIDS), large cap, small cap, international, and so on. Options premiums on some index ETFs may be more capital intensive.

As an alternative, you could focus on specific sectors.

2. Sector ETFs

  • The underlying is based on specific sectors.
  • The S&P 500 has 11 broad sectors.
  • To visualize sector performance, select the MarketWatch tab on the thinkorswim® platform. Then, select Visualize > Indices > expand S&P 500. All 11 sectors will be listed. Select one to get a glance via the Heatmap.

Game plan: As you scroll down the sector list, perhaps you notice that Real Estate appears to be strong. To find ETFs that focus on Real Estate, log in to your tdameritrade.com account and check out the ETF Market Center.

Look through the different sectors and find some that meet your trading criteria. Then add them to your watch list.

But what if you want to diversify your portfolio with assets uncorrelated to stocks?  

3. Bond ETFs

  • The underlying generally moves in line with its respective bond futures contracts.
  • Economic data, such as changes in interest rates, can impact bond prices, especially those with the longest maturities.
  • They give traders exposure to the bond market without trading futures.
  • They’re not as liquid as futures.
  • Bonds and bond ETFs will typically decrease in value as interest rates rise.

Game plan: Pull up a chart of the 30-Year Bond Futures (/ZB) on thinkorswim. Compare it with the chart of a 20- or 30-year Treasury-bond ETF. If both move in line, analyze price movement on the futures to help you make trading decisions. But only a couple of bond ETFs are liquid, so make sure the ETFs meet your minimum liquidity threshold. You could also try other ETFs that follow the futures market.

4. Commodity-Based ETFs/ETNs

  • Invest in physical commodities such as grains, livestock, energy, or precious metals.
  • Can hold commodities in physical storage or invest in the physical commodity and use futures contracts.
  • Some commodity exchange-traded products (ETPs) are technically exchange-traded notes (ETNs). See the sidebar, “What About ETNs?”
  • Give you exposure to the commodity market without trading futures.
  • Tend to be uncorrelated to stocks and bonds and can be used to provide a potential portfolio hedge.

What About ETNs?

ETNs are debt securities. Like ETFs, they track an underlying index. But because they’re loans issued by financial companies, you’re exposed to credit risk. ETNs also tend to be less liquid. But some ETNs give you exposure to products you typically may not have in the equity market, such as volatility or yield curves. So, they can be complex. And that means you really need to do your research before considering trading ETNs. To find out more, check out “Investing in Commodity ETFs: Agriculture, Oil, Gold ETFs, & More.”

Game plan: Consider following a broad-based commodity index such as the Bloomberg Commodity Index ($BCOM). Then focus on charts of futures contracts such as crude oil (/CL) or gold (/GC). Say /CL is rallying. You could potentially trade a liquid ETF that holds a basket of crude oil futures.

Also, keep in mind that commodities can be volatile and are affected by world events, government regulations, and economic conditions.

Now that you’ve got a better lay of the land, you can conclude your journey. But if you want some turbulence, stick around.

5. Leveraged/Inverse ETPs

  • Leveraged ETPs (both ETFs and ETNs) seek to provide daily leveraged returns based on the performance of an underlying index they’re tracking (e.g., 2x-3x). For example, a leveraged ETP may provide daily returns that are 3x the Russell 2000 Index (RUT).
  • Inverse ETPs are designed to increase in value when the value of a particular underlying index declines. For example, a leveraged inverse ETP might move -2x the SPX—and when the index declines, the ETP will gain value.
  • Typically riskier and more volatile and are not suitable for most investors.

These ETPs can be confusing and entail unique risks. So there’s a lot to think about before trading them. They either win or lose more than the market, or they make money when doing the opposite of the markets they’re tracking. Leveraged and inverse ETPs generate returns through the use of derivative positions. And because derivatives are taxed differently from equity or fixed-income securities, these ETPs may not have the same tax efficiencies that investors have come to expect from many ETPs. Most of these securities are designed for daily use only and not intended to be held overnight or long term, which means they have to be monitored and managed actively.

Game plan: On thinkorswim, pull up a chart of a broad index, such as the SPX, select Studies > Add study > Compare with > Custom symbol… and enter a leveraged or inverse ETP symbol. It will overlay on the SPX chart. You can see when prices between the two were in line and when they diverged. Keep in mind that because leveraged/inverse ETPs are volatile, options premiums can be higher.

Volatility ETFs and ETNs

There’s a whole class of volatility products you could trade. Find out more about them.

Pairing Up

As you can imagine, there are many ways to trade ETF options: protective puts, covered calls, collars, and more. One strategy you may not have given much thought to is pairs trading. You can pair an underlying with an ETF (buy/sell ETF against a long/short stock position), pair two ETFs, pair two ETF options, and so on. Pairs trading can be applied when there’s a divergence between a pair that typically correlates.

Say the Technology sector has had a strong rally, but Utilities are weak. You think both sectors might revert to the mean. You could pair up a long Utility ETF with a short Technology ETF. It could be capital intensive, and if the pair moves against you, you might end up losing on both positions.

An alternative is to trade spreads using ETF options. For example, you could sell a put spread that’s out of the money (OTM) on a Utility ETF and sell an OTM call spread on a Technology ETF. Because the risk is defined and you’re putting up less capital, a loss may not be too catastrophic. But keep in mind that your max potential profit is limited and there could be a large capital requirement. And if Technology continues moving up and Utilities continue sliding, you could end up with losses on both sides of the trade. 

You can figure out the correlation between two ETFs on thinkorswim (see figure 1).

chart using PairCorrelation indicator in thinkorswim
FIGURE 1: HOW WELL DOES THE PAIR CORRELATE? You can use a threshold such as 0.6 to make it simpler to visualize the correlation. Higher than 0.6 may be strong, and less than 0.6 may mean the pair isn’t as correlated. Chart source: The thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.  
  1. Select the Charts tab and enter the two symbols in this format: “ABCD–XYZ”.
  2. Select Studies > Add study > All Studies > O-P > PairCorrelation.

You’ll see the PairCorrelation study displayed below the price chart. If the pair diverges, the indicator will drop. Even though it’s not a guarantee, the indicator could help you decide whether to enter a pairs trade or not.

Although the ETF galaxy is made up of thousands of ETFs, adding just a handful to your watchlist of trading candidates can come in handy. Get to know what makes them unique and you could discover a whole new world of trading products.  

Jayanthi Gopalakrishnan is not a representative of TD Ameritrade, Inc. The material, views, and opinions expressed in this article are solely those of the author and may not be reflective of those held by TD Ameritrade, Inc.

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Key Takeaways

  • Explore the five main exchange-traded fund (ETF) categories
  • Know the basics of index ETFs, sector ETFs, bond ETFs, commodity-based ETFs/ETNs, and leveraged/inverse exchange-traded products
  • Understand how to apply pairs trading strategies to ETFs

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Content intended for educational/informational purposes only. Not investment advice, or a recommendation of any security, strategy, or account type.

Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.

TD Ameritrade and all third parties mentioned are separate and unaffiliated companies, and are not responsible for each other’s policies or services.

Inclusion of specific security names in this commentary does not constitute a recommendation from TD Ameritrade to buy, sell, or hold.

Before investing in an ETF, be sure to carefully consider the fund’s objectives, risks, charges, and expenses. For a prospectus containing this and other important information, contact us at 888-669-3900. Please read the prospectus carefully before investing.

ETNs are not funds and are not registered investment companies. ETNs are not secured debt and most do not provide principal protection. ETNs involve credit risk. The repayment of the principal, any interest, and the payment of any returns at maturity or upon redemption depend on the issuer’s ability to pay. The market value of an ETN may be impacted if the issuer’s credit rating is downgraded. ETNs may be subject to specific sector or industry risks. Leveraged and inverse ETNs are subject to substantial volatility risk and other unique risks that should be understood before investing. ETNs containing components traded in foreign currencies are subject to foreign exchange risk. ETNs may have call features that allow the issuer to call the ETN. A call right by an issuer may adversely affect the value of the notes.

Leveraged and inverse ETFs entail unique risks, including but not limited to use of leverage; aggressive and complex investment techniques; and use of derivatives. Leveraged ETFs seek to deliver multiples of the performance of a benchmark. Inverse ETFs seek to deliver the opposite of the performance of a benchmark. Both seek results over periods as short as a single day. Results of both strategies can be affected substantially by compounding. Returns over longer periods will likely differ in amount and even direction from the target return for the same period. These products require active monitoring and management, as frequently as daily. They are not suitable for all investors.

Equity pairs trading is not suitable for all investors and requires active monitoring and management as the special risks inherent may expose investors to potentially unlimited losses.

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