ETF Trading Strategies


Trades like stock
ETFs are listed on stock markets and trade like shares of stock. You can buy as little as one share or as many shares as you like. They are popular among institutional investors because they can be shorted or bought on margin. They are continuously priced, allowing you to get up-to-the-minute quotes from your brokerage or financial advisor. They can be bought or sold at any time during the trading day. They can be optioned and make excellent hedge investments. Essentially, ETFs are utility stocks with applications for many diverse investment strategies. At the same time, because of consistent performance of the major indexes, they make excellent investments for the long term as well.

ETF shares must typically be bought and sold through a broker or financial advisor.



Short Selling
Short selling is an investment strategy whereby an investor can earn a return even when the investor believes a stock's value is going to fall. Technically, the investor borrows a security and then sells it for the current market price, holding a position in debt to the lender while waiting for a downturn. Generally a short sale is any sale in which the seller has borrowed the security. It is a legitimate trading strategy.

If the share price of the security does in fact decline, the short seller will purchase shares to lock in a profit, extinguish the short position and replace the shares previously borrowed with the new shares bought at a lower price.

Of course, if the stock rises in price, the short seller may elect to close out the position through a purchase, and absorb the resulting loss.

Firms are required to report their short positions as of settlement on the 15th of each month. A compilation is published eight business days after.



Covered Call
This popular type of stock option is often considered among the safest positions to take in the world of stock options. A covered call is an attempt to take advantage of a neutral or declining share value of a given stock. Here's how it works. The seller writes a call option on the stock while simultaneously holding an equivalent amount of the same stock. If the option expires, the writer keeps the premium. If the holder of the call "exercises" the option, then the seller must deliver the stock, but because the seller is already holding an equivalent amount of the stock, risk is limited (the seller doesn't have to provide the stock at a disadvantageous price and take a loss).

ETFs, because of their high liquidity, are more popular for writing covered calls than single-company stocks, which are seen as more likely to lose liquidity in bad market conditions. The top ETFs, such as QQQ, enjoy very high trading volumes, and so investors perceive them as excellent resources for hedging and other risk-mitigating strategies.



Hedge Investments
Highly liquid ETFs are widely used by investors employing hedge strategies and seeking to mitigate the risk of investments. Of all characteristics making a security desirable for hedging an investment, liquidity is perhaps the most important. The ability of a security to find buyers or sellers regardless of conditions helps mitigate risk in adverse market situations where a higher-risk security may become difficult to trade.

For long-term hedge strategies, adding a short-term or long-term investment position in a liquid ETF to a portfolio helps to diversify overall holdings by exposing the portfolio to the industries and economic sectors represented in the underlying index. Added diversification spreads a portfolio's investment risk across a broader range of industries and economic sectors, mitigating the potential impact of adverse price movement in any single industry or sector. Diversification itself, from this point of view, is a "hedge strategy," though it may lack the dollar-for-dollar correspondence of a classical hedge investment.

Short selling is one short-term hedge strategy many ETFs are well-adapted for. A portfolio with holdings in industries and sectors similar to those in the underlying index can use the ETF to offset risk in those categories in a much more direct way than in the above scenario. Specifically, a drop in portfolio value resulting from a price in underlying stocks is offset by a short position in the ETF as the ETF's price drops. If you as an investor anticipate market weakness in the sectors represented by an index, taking a short position on the ETF can reduce or eliminate the exposure of your portfolio to those sectors. As the market rebounds, the short position can be closed out to take full advantage of growth in those sectors. Again, high liquid ETFs facilitate this type of strategy.

Some ETFs have derivatives tied to them, offering more opportunities for mitigating risk with hedge investments. For example, buying put options on an ETF provides investors with protection against adverse price movements by "locking in" a current sell price in anticipation that prices will fall. Alternatively, selling futures contracts on an ETF are other ways to establish a short position in order to offset portfolio losses during periods of anticipated market weakness. With a full suite of derivative products in combination with each other, both retail and institutional investors are able to design a wide range of low-cost hedges uniquely tailored to their portfolio requirements.

Going Long-term
Although ETFs are perceived as utility stocks by the most active investors, originally they were conceived as long-term growth investments. In fact, they remain an excellent choice for a long-term investment strategy. Because they represent a basket of stocks from various companies making up an index, ETFs bring built-in diversity to a portfolio or 401(k). Because they follow the major indexes, they also allow your portfolio to branch out into a particular sector or country (or asset type), without needing to purchase a large number of shares.

The diversity and balance of ETFs are two characteristics sought after by any long-term investor, but what about performance? Exchange traded funds first emerged as a way of taking advantage of this long-term growth potential of the market indexes. When you buy shares of an ETF, you are investing in the value of the underlying index, and in its long-term growth potential.