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