4 Strategies to Trade Exchange Traded Funds

Exchange-traded funds (ETFs) can be ideal for beginners to trade due to their many benefits, such as low expense ratios, abundant liquidity, range of investment choices and diversification. In addition, these features also make ETFs a great product for various trading strategies that beginners can use. This article will look into ETFs and some of the ETFs trading strategies for beginners.

What are ETFs?

ETF is a type of pooled investment security that holds multiple underlying assets rather than a single asset, and operates much like a mutual fund. It is called an exchange-traded fund because it is traded on an exchange, just like how stocks are regularly traded. This is different from mutual funds, which are not traded on an exchange and trade only once per day after the market closes.

ETFs typically follow a specific sector, index, commodity, geographic location or asset.  Take for instance the SPDR S&P 500 ETF (SPY) tracks the S&P 500 Index which consists of the top 500 companies ^[1]. Anything from the price of a single commodity to a sizable and varied collection of securities can be tracked by an ETF. Traders that trade ETFs can gain instant exposure to a multitude of assets instantly. 

Why trade ETFs for Beginners

Trading ETF for beginners is an excellent start to get into the trading market because:  

Diversification  

ETFs allow traders a convenient and affordable way to instantly diversify across hundreds or even thousands of stocks (or other asset classes) by purchasing a single ETF unit. 

Low cost due to the low expense ratio 

The expense ratio measures how much of a fund’s assets are used for administrative and other operating expenses. ETFs are designed to be more passive in comparison to mutual funds. Thus, fund managers are not required to trade actively and manage the fund. This will lower the transaction fees that are incurred, hence lowering the overall expense ratio.

User-friendly

Most ETFs are tradable on exchanges like stocks so that traders can buy and sell ETFs quickly through their broker. In addition, ETFs trading price is updated throughout the active market day, which differs from a mutual fund, where the price is only updated at the end of the day. 

Limited capital gains tax 

 ETFs can be more tax efficient compared to mutual funds. ETFs that are passively managed see lesser capital gains than mutual funds that are actively managed. Unlike mutual funds, which pass on capital gains taxes to investors over the investment term, exchange-traded funds (ETFs) are only subject to capital gain tax when the trader sells the ETF.

4 Strategies for Beginners to Trade ETFs

1. Dollar-Cost Averaging (DCA)

The method of buying a constant quantity of an asset regularly, regardless of the asset’s fluctuating price, is known as dollar-cost averaging (DCA). Beginner traders may consider setting aside a fixed amount at the end of every month and use it to trade ETFs. This will also train traders to be more disciplined with accumulating units of the asset.

The cost of your ETF holdings will be averaged out if you invest the same fixed dollar amount in an ETF each month. By doing this, traders will amass more units when the ETF price is low and fewer units when the ETF price is high. Over time, this approach can be beneficial if one maintains discipline.

2. Swing Trading 

Swing trading is a method that seeks sizeable swings in stocks or other assets like currencies or commodities. Unlike day trading, the duration of a swing trade varies from a few days to a few weeks to complete. ETFs can be suitable for beginners to swing trading because they are available in many sectors. Traders can trade based on a sector or asset class they are more familiar with, such as purely trading gold ETFs, the top 500 US stocks, or even a specific country’s ETF. 

As ETFs are typically a pool of stocks or other assets, traders are less susceptible to sudden price movements than being exposed to a single stock. This offers some protection against capital erosion for beginners.

3. Sector Rotation and Seasonal Trends

ETFs also make it possible for beginners to implement sector rotation trade based on the current economic sectors that are in demand and doing well. For example, during the start of the Covid-19 pandemic, clean energy stocks had a good market run as the fossil fuel sector was slowing down. The ETFs such as Invesco Solar ETF (TAN) and First Trust Nasdaq Clean Edge Green Energy Index ETF (QCLN) saw a return of over 100% since the beginning of the pandemic ^[2]. The trader would then buy into the pharma sector ETFs. Once the clean energy sector is slowing down, the trader can sell the ETFs and make potential returns. Traders can then rotate to a different sector to trade in.

ETFs can also be used to create opportunities on seasonal trends. For example, during the wedding season and the Diwali festival of lights, there will be a surge in gold demand in India during this period ^[3].  A trader could consider buying gold-specific ETFs during this period and choose to close the position when the demand for gold decreases.

4. Hedging

Hedging against investment risk means strategically using financial instruments or market strategies to offset the risk of any adverse price movements ^[4]. In simpler terms, traders hedge one trade by making a trade in another. Beginners may occasionally need to hedge or protect against downside risk in their overall portfolio. 

For example, if a trader with a sizable portfolio of US blue chip stocks is worried about the possibility of a decline in US equities, one possible consideration is to use put options. Since most beginners are unfamiliar with option trading strategies, an alternative is to initiate a short position in ETFs like the SPY.  When the market declines as expected, the trader’s US blue chip stocks position will be hedged effectively due to the gains in the short ETF position. If the market advances, the trader’s gain will be capped since losses in the short ETF position offset the trader’s portfolio. ETFs can therefore provide beginners with an asset class help hedge their portfolios.

Conclusion

With their various features and potential advantages, ETFs can make an ideal product for beginners to trade with. Some ETF trading strategies require more knowledge, while others can be relatively straightforward. 

Open a demo or live account with Vantage and begin implementing the trading strategies to trade ETFs today.

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