The Way to Kickstart Your Economic Recovery
Thursday, July 30, 2009 | Price Headley
The recent market volatility has been nice to see happening on the upside for a change. However, don't get lulled to sleep, as too many traders are now too bullish based on my sentiment analysis.
This tells us we're due for a cooling-off phase very shortly.
You might have banked some decent profits in the recent run-up, but how do you prepare your portfolio for what's coming next?
My Favorite Way to Trade
I continue to receive a significant number of e-mails asking about Exchange-Traded Funds (ETFs). More specifically, most inquiries are especially interested in the prospects for ETF options, which have exploded in popularity over the past few years.
In fact, some traders find ETF options more advantageous to trade than standard (stock) option contracts, as their option chains typically offer strike (or, exercise) prices in 1-point intervals, whereas stock options tend to be listed in $2.50 or $5 increments, depending on the price of the stock.
The issue with ETFs and ETF options used to be liquidity, but things have changed in that regard. Due to the advantageous architecture of ETFs, more investors are hedging their portfolios with ETF options.
To understand the reason these vehicles are changing the options environment, let's take a look at the underlying securities and their benefits.
1. ETFs Trade Like a Stock -- Unlike mutual funds or hedge funds, which can only be entered or exited at the market close each trading day, ETFs can be bought and sold intraday. They can even be day-traded just like stocks.
This advantage allows investors to make speculative bets on the direction of an index while still having the ability to exit the trade at any time of the day. ETFs also allow short-selling, as well as often being optionable.
2. Diversification -- One of the main benefits of trading ETFs is diversification. ETFs were created to track an index -- be that a stock index, commodity index, currency index or almost any other type of security index. The advantage of trading an index is that you are shielded from the volatile up-and-down swings of a given individual security.
3. Liquidity -- There are many funds that are highly liquid. The QQQQ fund (which follows the Nasdaq-100 Index) has an average daily trade volume of more than 164 million shares and over 75 other funds have an average daily volume of more than 1 million shares.
Liquidity is important to get in or out of a position quickly. There are a lot of other buyers and sellers to facilitate your trades, as opposed to relying on market-makers to do everything for you. If you are trading options on the funds, many of these also have highly liquid options.
4. Low Bid/Ask -- As a result of high liquidity, many ETFs have low bid/ask spreads. A high bid/ask spread can cut into your trading profits. Most of the highly liquid ETFs have a bid/ask spread of only a few cents during the trading day.
5. Variety -- Whichever sector of the market interests you, you can probably find an ETF for it. There are major index funds such as the QQQQ (also known as the "Qs") and the S&P 500 SPDR (SPY), as well as sector funds such as the Financial Select Sector SPDR (XLF) and international funds such as the Emerging Markets Index (EEM).
In addition to sector-specific ETFs, fund companies are continually introducing "Ultra" and "inverse" ETFs. "Ultra" ETFs are leveraged funds in which the returns of the fund are double that of the index. For example, if an ETF is up 10% for a given year, then the Ultra ETF for that same index would be up around 20% in the same year.
Keep in mind that this leverage can work for you, as well as against you.
"Inverse" ETFs are funds that move in the opposite direction of the underlying index. So if the S&P 500 Index (SPX) is down 8%, then the inverse ETF for the S&P would be expected to be up 8%. To further increase your investing options, some Ultra ETFs are also inverse funds as well.
6. Low Expense Ratios (Lower Fees) -- ETFs have much-lower expense ratios than mutual funds or hedge funds. This means that more of your money stays in the investment rather than going to the firm that is maintaining it.
An increasing number of traders and investors are using Exchange-Traded Funds, as evidenced by growing volume trends, suggesting to me that ETFs will become a preferred investment vehicle for most investors, largely leaving traditional mutual funds to stagnate.
This growth is demonstrated by the increasing availability of ETF alternatives across a wide variety of sectors and foreign markets, and of course options on ETFs give you even more access to creating a diversified portfolio of ETF exposure, at a much lower cost.
Trade Well!
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Price Headley
Chief Investment Officer
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