Going hand-in-hand with a recent post on a Chinese ETF known as FXI, we are following up with a post that offers a more comprehensive look at the entire ETF category.

In a recent episode of Best Practices, hosts Tom Sosnoff and Tony Battista dial up a thorough review of some important concepts and insights to keep in mind when trading ETFs.

An ETF is of course an Exchange Traded Fund (ETF). An ETF is a publicly-traded financial product that tracks an index, commodity, or basket of assets. As you might imagine, ETFs closely mirror the returns of the index, commodity, or asset that they represent.

There are several important reasons that ETFs are often utilized by traders to increase or decrease risk in their portfolios. Several of these reasons are listed below:

  • Lower specific risk: ETFs are made up of many individual components, which means single-security risk is substantially lower. Large moves in individual names or the broader market are mitigated by diversification.
  • Less capital intensive: Almost every investor can access ETFs and compared to index options and futures, the price tag is much lower.

The two points above also mean that ETFs often have a lower implied volatility than their components - directly related to the reduction in perceived risk. Lower implied volatility usually translates to lower premiums paid.

The graphic below illustrates how the ETF known as XLE, which is comprised of energy stocks, has a lower implied volatility than almost every one of the larger components:

It's important to keep in mind that ETFs can also be of the "leveraged" variety. Leveraged ETFs are a subset within the ETF category that literally use "leverage" (debt and derivatives) to track different products, but with an amplification multiplier.

For example, the SPX is the S&P 500 cash-settled index. The SPXL is a leveraged ETF that is designed to trade 3x more bullish than the SPX. That means that for every 1% move in the SPX, the SPXL will move 3%.

It's critical to understand the difference between normal ETFs and leveraged ETFs because obviously the latter will be a much more volatile security to manage in your portfolio. Even seasoned traders step gingerly in the leveraged ETF realm.

However, normal ETFs are frequently-traded products and listed below are some most commonly featured on the tastytrade network:

bestpractices090815trade-etfs_mstr-4.png

On the balance of this Best Practices episode, Tom and Tony provide further insights on trading ETFs, particularly covering the subject of scale and portfolio size. This process involves determining the notional value of an index or commodity then calculating the number of shares/options necessary to replicate the larger product.

We encourage you to watch the entire Best Practices episode focusing on ETFs when your schedule allows.

If you have any comments or questions on Exchange Traded Funds, please don't hesitate to contact us at support@tastytrade.com. We greatly value your input.

The entire Best Practices library is accessible through this link.

Happy Trading!