ETF Trading Strategies (Setup And Rules+Video)
One of the most ideal investment vehicles for beginner investors, ETFs have grown in popularity since they emerged on the financial markets. But what is an ETF, and how is it traded?
An exchange-traded fund (ETF) is a basket of securities that is traded as a single instrument, which you can buy or sell through a brokerage firm on a stock exchange. Investing in certain ETFs is mostly seen as a passive approach, but ETFs can also be actively traded using various strategies.
In this post, we will discuss the following:
- What is an ETF?
- History of ETFs
- ETF trading strategies
- The pros and cons of ETFs
ETF trading strategies
Most of the backtests on this website are tested on ETFs. It could be SPY, XLP, USO, or TLT, for example. As a rule of thumb, the difference between a future backtest and ETF backtest should be minimal in liquid assets.
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What is an ETF?
An exchange-traded fund (ETF) is a basket of securities that is traded as a single instrument, which you can buy or sell through a brokerage firm on a stock exchange. That is, an ETF can be bought and sold like a company stock during the day when the stock exchanges are open.
As with a stock, an ETF has a ticker symbol, and its intraday price data can be easily obtained during the course of the trading day. But unlike a company stock, the number of shares outstanding of an ETF can change daily because new shares are continuously created and existing shares are redeemed. It’s the ability of an ETF to issue and redeem shares on an ongoing basis that keeps its market price in line with the underlying security it tracks.
Interestingly, ETFs are offered for virtually every conceivable asset class — from traditional investments to so-called alternative assets like commodities or currencies. ETFs are one of the most important and valuable products created for individual investors in recent years. The innovative structures of ETFs allow investors to short markets, gain leverage if they want, and avoid short-term capital gains taxes.
ETFs offer many benefits and, if used wisely, are an excellent vehicle to achieve an investor’s investment goals. While they are initially designed for individual investors, institutional investors play a key role in maintaining the liquidity and tracking integrity of the ETF. They do this through the purchase and sale of creation units, which are large blocks of ETF shares that can be exchanged for baskets of the underlying securities.
There are different types of ETFs. The common ones include:
- Index ETFs
- Sector and industry ETFs
- Foreign market ETFs
- Bond ETFs
- Commodity ETFs
- Inverse ETFs
- Leveraged ETFs
History of ETFs
The history of ETFs can be traced to 1989 when Index Participation Shares for the S&P 500 was launched. However, a federal court in Chicago ruled that the fund worked like futures contracts.
In 1990, the Toronto 35 Index Participation Units (TIPs 35) was created. But it was in January 1993 that the first recognized exchange-traded fund, the S&P 500 Trust ETF (the SPDR or “spider” for short), was launched. This ETF quickly became very popular, and it is still one of the most actively-traded ETFs in the U.S. stock market.
Since 1993, the ETF market grew tremendously, reaching 102 funds by 2002, and nearly 1,000 by the end of 2009. As of May 2020, there were more than 7,100 ETFs (from over 160 distinct issuers) trading globally, according to research firm ETFGI. On the U.S. stock market alone, ETFs are estimated at 5.83 trillion dollars with nearly 2,354 ETF products as of 2021.
The pros and cons of ETFs
The pros of ETFs include the following:
- ETFs offer diversification: For most ETFs, just investing in one ETF can give exposure to not only several stocks but also multiple market sectors.
- They trade like stocks: ETFs do not only give the holder the benefits of diversification but also offer the trading liquidity of equity. Unlike a mutual fund that is priced at the end of the day at the net asset value, an ETF trades like a stock.
- Fees may be lower: Compared to mutual funds, which are actively managed funds, ETFs have much lower expense ratios because they are passively managed.
- Dividends are automatically reinvested: The dividends from companies in an open-ended ETF are automatically reinvested once they are issued.
Despite the many benefits, ETFs come with some demerits. They include:
- Lower dividend yields: For dividend-paying ETFs, the yields are not as high as owning a high-yielding stock or group of stocks. While the risks associated with owning ETFs are usually lower, the dividend yields are also lower.
- Returns are skewed: Some ETFs are leveraged, and the returns on such ETFs are usually skewed. For example, double or triple leveraged ETFs can lose more than double or triple the index they track.
Some Frequently Asked Questions (FAQ)
What is the best ETF strategy? Are there best ETF trading strategies?
There is no best ETF trading strategy, period.
Instead, you want to have many trading strategies that trade different ETFs, time frames, and market directions – both long and short. The power is in diversification and strategies that complement each other. Diversification is the only holy grail strategy in trading.
Can you swing trade ETFs?
Of course you can! The strategies in this video show examples of how it can be done. As a matter of fact, we believe swing trading is much better than day trading.
What are the advantages of ETF trading strategies?
The main advantage is that you invest in a basket of stocks, and thus, you reduce the chances of gut-wrenching adverse movements. A single stock can fall 100% and rise unlimited, forcing you to go belly up if you are short.
Moreover, ETFs can be a great substitute if you are trading single stocks: ETFs can be used for hedging or diversification, for example.
Also, if you are investing, you get exposure to the whole market in a second when you buy SPY or QQQ, for example.
What are the disadvantages of ETF trading strategies?
The disadvantage is that you are unlikely to have huge winners. A stock can rise 500%, but this is unlikely for an ETF unless you have owned it for decades.
However, for most retail traders, the wisest thing to do is to buy different asset classes and let time do the compounding.
Are ETF trading strategies good for beginners?
We believe so. However, you should always start trading in a demo account and wait at least 12 months before you go live with a backtested ETF strategy. This is called incubation. We believe it’s better to trade ETFs before you start trading individual stocks.
Are ETF trading strategies best for long or short term trading?
We think you should trade both long- and short-term. You want to diversify into several strategies that complement each other. As mentioned further up in the article, diversification is the only Holy Grail in trading, and this includes different time frames.
What are the best ETF trading strategies?
There is no single best ETF trading strategy; you want a portfolio. Again, you want diversification!
Can you day trade ETF trading strategies?
Sure, but day trading is significantly harder than swing trading. Day trading is noisy, meaning it’s hard to find tradable patterns that last long. We believe the best opportunities for retail traders are in using a longer time frame, for example, daily, weekly, or monthly bars. If you are not successful at swing trading using daily bars, we believe the chances of success as a day trader are slim.
Relevant article
An option for ETF trading strategies is futures trading strategies. Normally, these two types of trading vehicles track the same asset but they are somewhat different: