WHAT IS AN ETF?
ETF is short for Exchange Traded Fund. ETF’s have exploded in popularity in the last few years due to their flexibility, diversification, and ease of trading. An ETF is a security that tracks and mirrors the performance of an index, commodity, or sector and trades in shares (like a stock) on an exchange. With the rising fame of ETF’s there are now ETF’s that track baskets of other ETF’s as well as leveraged and inverse ETF’s.
An ETF is actually a sort of quasi mutual fund whose shares trade like a stock intraday; in fact, from a trading and execution point of view, there is no difference between an ETF and a typical stock. ETF’s can be traded on margin, sold short, and traded with stop, limit or market orders like all other equities.
As mentioned, ETF’s have expanded recently to include inverse and leveraged ETF’s. Inverse ETF’s move in the opposite direction of the index/commodity/sector they track. Therefore, if I am bearish on the price oil, I can purchase the ETF: DDG, which is the inverse oil ETF. As a result, if I am right and the price of oil falls 3%, the DDG will rise by 3%, and vice versa.
Leveraged ETF’s have been introduced that perform at 2 and even 3 times what they track. 2xleveraged, 3xleveraged ETFs, as well as inverse 2xleveraged, 3xleveraged ETFs have become very popular recently. Please understand: These ETF’s are on steroids! Meaning, when the index/commodity/sector they track moves up by say, 4%, these ETF’s will increase or drop by 8% for the 2xleveraged and 12% for the 3xleveraged, respectively!
*Note - The saying about these instruments is, “when you’re right you’re really right, but when you’re wrong, you’re really wrong!” I caution most all traders to avoid these instruments unless they have more money than smarts; and if that’s the case, just set fire to the money, it will be less stressful!
One of the benefits of ETF’s is that an investment thesis can be implemented without any single stock risk exposure. That means that an investor is not exposed to single stock “event risk” (negative earnings release, lawsuit, fraud, etc). Risk is spread across the entire sector and is therefore mitigated. For example, a bullish opinion on semiconductors can be executed by buying the ETF: XLK. By doing so, an investor gains exposure to essentially every stock in the semiconductor sector and the single stock exposure is eliminated. This benefit becomes invaluable when a stock has a negative event like a negative news release. If that specific stock is owned then the investment could lose money on a falling share price. However, if the ETF is owned, and the semiconductors as a whole are performing well, the investor will be enjoying a profit as the sector performs well and the ETF rises in price.
Options also exist for ETF’s just like other equities. The wonderful part about pairing options and ETF’s is that specific sector bets can be placed long or short with the leverage and hedging capabilities of options. ETF option trading should be a major focus for all investors, no matter what their risk profile.
ETF’s track a sector or index and trade like stocks
ETF’s eliminate single stock exposure known as “event risk”
Options are available on ETFs just like other equities.
Leveraged ETF’s are only for the most experienced traders. Enter at own risk!
Make sure to check out my latest interview with Benzinga.com