Trading ETFs

What is an ETF?

What is an ETF you ask? A wicked trading vehicle… thats what.

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.

It’s important that you understand that trading ETFs is not the same individual stocks or companies. Instead of being looked at as such, consider them representative funds for assets (gold, oil, silver, etc.) If the asset is doing well, the ETF will likely follow. However, since ETFs are not individual securities, trading them can be challenging and even confusing at times, as their price action will vary slightly from typically stocks, especially when trading leveraged ETFs.

Right… so break it down further – What is an ETF?!

Obviously, the formal definition of an Exchange Traded Fund can be found at the beginning of this article. 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 on that definition…

An ETF can best be described as a type of fund that owns underlying assets (be it shares of stock, bonds, gold bars, oil futures, foreign currency, etc.) and 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. They rather own these assets indirectly. Long-term ETF shareholders are entitled to earned interest or dividends, and they are able to claim residual value if the fund were to be liquidated. Since ETF shares are traded on public exchanges, at any time the fund can easily be bought, sold or transferred.

By trading ETFs, traders can get the ability to short an index or asset, in addition to the ability to buy on margin. Another huge advantage is the expense ratios for most ETFs are significantly lower than the actual asset.

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% drop in the true price gold. Leveraged ETFs gain a multiple return of the true return. A 2x ETF on gold would gain 2% for every 1% gain in the true price of gold. Leveraged inverse ETFs also exist, in a negative 2x or 3x form. 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 are essentially mirrored versions of one another. This same strategy of comparing the two can also be applied to monitor crossovers of the normal and inverse ETFs for an asset.

In 2006, ProShares established the first wave of leveraged ETFs, which are still referred to by the company as “Ultra ProShares.” These leveraged ETFs are designed to double the daily performance of the underlying asset they track. As an example, $DDM (ProShares Ultra Dow 30) is designed to gain 2% when the Dow gains 1%. On the flipside, $DDM will lose 2% if the Dow loses just 1%. ProShares was just the first, now there are several.

In their prospectus for leveraged ETFs, ProShares clearly states that investors shouldn’t expect long-term performance to double the underlying asset. However, it doesn’t make this very clear when these leveraged ETFs are advertised. As a result, most average investors will buy them thinking just that. For this reason, it’s important that you be aware before entering a trade in a leveraged ETF, the goal isn’t to hold it long term, but to double or triple the potential gains on the move of the actual asset, for the day (not the week or month.)

Everything on this site is aimed at a trader’s mentality, not an investor’s. This article is no different. At no point would I encourage or recommend you to buy and own and leveraged ETF or ETN long-term. If this is your interest, considering reading this on ETFs and this on ETNs first.

Similarities and Differences Between Trading ETFs and ETNs

Similar to ETFs, ETNs are also traded on major exchanges, like the NYSE and AMEX during normal trading hours. When you trade an ETF, you’re trading a piece of a diversified portfolio of an asset. However, when you trade an ETN, you’re trading a “promise” of a payoff of debt, or a “promise” that the issuer will pay the note according to the terms laid out in the ETN’s prospectus. But be aware, there is no guarantee it will be paid, and no regulation to force such a payment.

Long-term investors have the option of holding the ETN until maturity. At the time of maturity, the issuer will pay the investor a cash amount that would be equal to the principal amount, aside from any commissions and/or fees.

What makes ETFs and ETNs different is essentially holding for a period of time. If you’re a day trader and plan to exit the position in the short-term, then they trade very similarly. However, if you’re considering long-term, know that ETNs pay no interest or dividend distribution, which means no annual tax. Capital gains — or losses are realized when an investor sells the ETN, or when it matures.

One important factor that will affect the potential value of an ETN is the credit rating of the issuer. The value of the ETN may decrease despite the underlying asset going unchanged. This decrease in value would potentially be as a result of a downgrade in the issuer’s credit rating.

The Key to Trading ETFs & ETNs

New traders will often catch light of a ticker and trade it frequently, lets say $UWTI as an example. The ETN is extremely cheap at less than $2/share currently, essentially meaning a much cheaper way to trade oil for those holding less capital in their accounts. Seems like a jackpot find, but is it?

They proceed to analyze the chart as if it were a stock of it’s own. They may even look at the weekly and think “hell it was in the 400s just last year. It’s oil. It’ll come back.” Little do they know that the entire key to trading $UWTI is actually in $USOIL or /CL, not $UWTI itself. They probably also won’t realize that $UWTI has been through several splits, only decreasing the value of each individual share. Without reverse splits, $UWTI may never see that $400 level again, even if $USOIL makes new highs. This is precisely the reason I say do not trade leveraged ETFs or ETNs long term.

The key is not in the ETF or ETN’s price action. The key is in the price action of the index, asset, or sector that the ETF or ETN is tracking. Before you trade an ETF/ETN, check out the full ETF database at ETFDB.com. Do a little bit of research on the fund you plan to trade, and find out 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 hourly chart to demonstrate how $SPY reacts to the price action of the S&P 500.

In some cases, you will be shocked to 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 of trading.

Below, I’ve included some top traded ETFs & ETNs to hopefully assist you in your profiting:

Top Traded ETFs/ETNs

Trade the VIX ETFs/ETNs

Popular 2x ETFs/ETNs

Popular 3x ETFs/ETNs

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:

Yahoo Finance – Search for any ETF or ETN 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, great database of every ETF/ETN.

2xetf.com – Full list of all 2x leveraged ETFs/ETNs.

3xetf.com – Full list of all 3x leveraged ETFs/ETNs.

For inexperienced traders, I would advise you to trade individual securities before considering branching out to expand to ETFs and/or ETNs. As for the experienced traders, I genuinely hope this helps with your trading.

If you learned something useful by reading this, share it with others. Godspeed Traders.