What is an ETF?
What is an ETF, you ask? A great trading vehicle… if you understand where it’s price action comes from.
Exchange-Traded Fund (ETF): A security that tracks a set of equities, very similar to an index. An ETF is traded just as a normal share of stock is traded on an exchange, and has it’s price adjusted throughout the day, rather than at market close (like a mutual fund). ETFs are typically made up of stocks that are within a similar industry, like energy or metals, but can cover an index of equities as well.
You must understand that trading ETFs is not the same individual stocks. Instead, look at them like representative funds for assets (gold, oil, silver, etc.) or groups of companies. If the asset or group of companies is doing well, the ETF will likely follow. However, trading ETFs can be challenging and even confusing at times. ETF price action will vary slightly from typical stocks, especially when trading leveraged ETFs.
Right… so break it down further – What is an ETF?!
So we covered the formal definition of an ETF above. But if you aren’t already familiar with market terms, this definition may have left you still wondering, “so… What is an ETF?” Let’s elaborate a little more on that definition.
An ETF can best be described as a type of fund that owns underlying assets (be it shares in companies, bonds, gold bars, oil futures, foreign currency, etc.). The ETF then divides it’s ownership of those assets into shares.
Shareholders don’t actually own or have any direct claim to the underlying assets in the fund. Instead, they own these assets indirectly. Long-term ETF shareholders are entitled to earned interest or dividends. They can also claim residual value if the fund were to be liquidated. Since ETF shares trade on public exchanges, at any time, the fund can easily be bought, sold, or transferred.
By trading ETFs, traders can get the ability to trade an index or asset. An index would be the S&P 500, Russell 2000, or Nasdaq 100. An asset would be things like oil, gold, or silver. These indices and assets trade on futures markets and directly affect the stock market prices. Unless you trade futures, the indices and assets are not directly tradable unless you trade them using ETFs.
Inverse and Leveraged ETFs
Certain ETFs use leverage to create inverse (short) or leveraged (2x/3x) ETFs.
Inverse ETFs track the opposite of the true return of the underlying asset. An example of an inverse ETF on gold would gain 2% for every 2% gain in the true price of gold.
Leveraged ETFs gain a multiple (2x/3x) of the true return. A 2x ETF on gold would gain 4% for every 2% gain in the true price of gold.
Leveraged Inverse ETFs also exist in a 2x or 3x form. These are combinations of a multiple that does the opposite of the underlying.
Both UPRO (S&P 500 3x) and SPXU (Inverse S&P 500 3x) are plotted on the chart below as an example. Notice that they essentially mirror one another.
Leverage ETFs Can Be Trouble
In 2006, ProShares established the first wave of leveraged ETFs. The company still refers to these as “Ultra ProShares.” These ETFs are aim to double (or triple) the performance of the underlying asset(s) they track.
In their prospectus for leveraged ETFs, ProShares clearly states that investors shouldn’t expect long-term performance to double the underlying asset. However, they don’t make this very clear when they advertise these funds. As a result, beginner investors will buy them thinking just that. For this reason, you must be aware of this before entering a trade. Leveraged ETFs are meant to capture short-term gains. They are not long-term financial instruments.
The Key to Trading ETFs
New traders will often catch light of a ticker and trade it frequently. Let’s use NUGT as an example. The ETF is essentially a much cheaper way to trade gold for those holding less capital in their accounts. It seems like a jackpot find, but is it?
They analyze the chart as an individual stock of its own. They may even look at the weekly and think it will return to prior levels at some point.
Little do they know that the entire key to trading NUGT is actually in Gold Futures (or /GC). They probably also won’t realize that NUGT has been through several splits, only decreasing each share’s value. Without reverse splits, NUGT will likely never see prior highs again, even if Gold can make new highs. This is precisely the reason to avoid trading leveraged ETFs long term.
Know What the ETF Tracks
The key is not in the ETF’s price action. The key is in the price action of the index, asset, or sector that the ETF is tracking. Before you trade an ETF, find out the details of the ETF at ETFDB.com. Do a little bit of research on the fund you plan to trade and determine what that security tracks. Once you find out what it tracks, find out how to track that asset. When all else fails, Google it. Below is an example of the SPY ETF (line chart) compared to a candle chart of SPX, both on an hourly chart, to demonstrate how SPY reacts to the price action of the S&P 500.
In some cases, you may see some lag between the asset and the ETF. The asset may begin to tick up before the ETF reacts to make the same tick. If you catch on to this lag, it can make your entire day (or week) of trading.
Below I’ve included some top traded ETFs to hopefully assist you in your profiting:
Top Traded ETFs
| ETF/ETN Ticker | What it Tracks |
|---|---|
| SPY | S&P 500 |
| IWM | Russell 2000 |
| QQQ | Nasdaq 100 |
| DIA | Dow Jones Industrial Average |
| OIH | US Oil Services |
| XLE | Energy Sector |
| XLF | Financial Sector |
| IYR | US Real Estate Index |
| BBH | Biotech |
| USO | Light Sweet Crude Oil |
| GLD | Gold |
| SLV | Silver |
| UNG | Natural Gas |
Trade the VIX ETFs
| Ticker | What it Tracks |
|---|---|
| VXX | S&P 500 Short-Term VIX Futures |
| VIXY | VIX Short-Term Futures |
| XIV | Inverse (Short) VIX Short-Term |
| SVXY | Short VIX Short-Term Futures |
| TVIX | 2X Short-Term VIX |
| UVXY | 2X Short-Term VIX Futures |
Popular 2x ETFs
| Ticker | What it Tracks |
|---|---|
| UCO | Crude Oil 2x |
| SCO | Inverse Crude Oil 2x |
| BOIL | Natural Gas 2x |
| KOLD | Inverse Natural Gas 2x |
| QLD | Nasdaq 100 2x |
| QID | Inverse Nasdaq 100 2x |
| UWM | Russell 2000 2x |
| TWM | Inverse Russell 2000 2x |
| SSO | S&P 500 2x |
| SDS | Inverse S&P 500 2x |
Popular 3x ETFs
| Ticker | What it Tracks |
|---|---|
| FAS | Financial 3x |
| FAZ | Inverse Financial 3x |
| TNA | Small Caps 3x |
| TZA | Inverse Small Caps 3x |
| ERX | Energy 3x |
| ERY | Inverse Energy 3x |
| SPXL | S&P 500 3x (Direxion) |
| SPXS | Inverse S&P 500 3x (Direxion) |
| LABU | Biotech 3x |
| LABD | Inverse Biotech 3x |
| NUGT | Gold Miners 3x |
| DUST | Inverse Gold Miners 3x |
| GASL | Natural Gas 3x |
| GASX | Inverse Natural Gas 3x |
| UPRO | S&P 500 3x (Proshares) |
| SPXU | Inverse S&P 500 3x (Proshares) |
| TQQQ | Nasdaq 100 3x |
| SQQQ | Inverse Nasdaq 100 3x |
| UDOW | Dow Jones 3x |
| SDOW | Inverse Dow Jones 3x |
| UWTI | Crude Oil 3x |
| DWTI | Inverse Crude Oil 3x |
Conclusion
Trading ETFs can be tricky. If you have experience trading them, then the above information likely made a lot of sense as you read it, especially looking back in hindsight. However, if you’re new to trading ETFs, experiment a little first before diving in. Consider pulling up both the ETF and the underlying asset on the same chart (as I did above with SPY and S&P 500) to follow/trade, or even consider paper trading it first. Nothing trumps experience.
A few helpful links for ETFs would be:
Trade Ideas Software – An incredible intraday scanning software, and probably one of the best places to find ETFs that are moving. The platform features a dedicated ETF channel, with scans featured that are specific to ETFs.
Yahoo Finance – Search for any ETF on Yahoo Finance. Once you are on the page giving the details for the fund, on the left side under “ETF” you can click on “holdings” and very every individual stock or asset within the fund.
ETFDB.com – As mentioned before, a great database of every ETF.
2xetf.com – Full list of all 2x leveraged ETFs.
3xetf.com – Full list of all 3x leveraged ETFs.
If you learned something useful by reading this, share it with others.
You are right, if you have experience in trading EFTs then this article probably makes a lot of sense. However, for the novice like me, it was a little confusing. About all I got from it was that trading EFTs is a good idea. However, I will obviously need to learn more before getting my feet wet here. Any suggestions for where I should start?
Happy to help, as always. However, if “getting your feet wet” refers to trading in general, I wouldn’t recommend that you begin with ETFs. That being said, if “getting your feet wet” refers strictly to ETFs, try this ETF Basics Part 1
Hope it helps.