What are Exchange Traded Funds, and How Do You Trade Them?
An exchange traded fund (ETF) is a basket of stocks, currencies or commodities that are used by investors to take or manage risk. There are several different types of ETFs, many of them track indices such at the S&P 500 or the Nasdaq 100. Some track currencies or commodities. There are also many strategies that you can use to invest in ETFs including directional strategies, pair strategies and hedging strategies.
What Composes and ETF
ETFs are made up of different types of financial instruments used to track an index, commodity or currency. ETFs that are used to track indices are generally made up of stocks within the index. For example, the SPY (SPDR 500 Index) holds the stocks within the S&P 500 index. If a stock is added to the index or removed, the operators of the SPY need to add or subtract that stock from the index. There are many different indices tracked by ETFs. In addition to tracking large indices, some track sectors. For example, the XLF ETF tracks the US financial sector.
In addition to tracking indices, some ETFS track commodities. There are a couple of types of commodity ETFs. Those that track the underlying commodity and those that track the companies that produce or refine those commodities. The ETFs that track the underlying commodities generally hold the physical commodity or futures contracts relating to that commodity. For example, the GLD (Gold Trust ETF) holds both physical gold bullion and gold futures contracts.
There are also currency ETFs. These ETFS are expected to track the movements of a currency pair. Generally, these ETFs track the movements of specific currency pairs. For example, the FXE (Euro trust ETF) tracks the movements of the EUR/USD.
How to Trade ETFs
There are several ways to trade an ETF. You can trade them directionally like a stock, index or currency pair. This can be done using either fundamental or technical analysis. You can trade an ETF as a pair. For example, you can purchase one ETF and simultaneously sell another ETF betting that the relative value of one ETF will outperform another ETF. For example, if you believe that the financial sector will outperform the energy sector, you can purchase the financial ETF XLF and sell the energy ETF XLE. This is a market neutral strategy called a pair trade.
ETFs provide investors with a product that can be used to initiate risk as well as hedge risk. You can also use ETFS to hedge your stock or commodity exposure. For example, if you own a basket of financial stocks you might consider selling the XLF (financial ETF) to hedge if you expect financial shares to temporarily fall. You might do this with a broader ETF like the SPY (S&P 500 index) ETF if you believe there might be a broad market correction.
ETFs provide investors with a product that can be used to initiate risk, as well as hedge risk.