Hi readers! Hope you’re in the mood for something interesting. Because today we’re discussing one of the most interesting tradable CFD instruments available online. This product is called ‘ETF’, which actually stands for ‘Exchange Trade Funds’. Yes, we know – that doesn’t mean much to you right now, but trust us: After you read this short article you will have a much better understanding of this instrument and why it’s so popular among online traders.
Now, let’s begin with a quick explanation…
Essentially, an ETF is a tradable instrument that tracks an index, a commodity, bonds, or a basket of assets like an index fund.
Or, in simpler words…
Do you know the old saying that goes “don’t put all your eggs in one basket”? Well, the newer saying goes “put all your eggs in one basket and then watch the basket”.
When you’re trading ETFs in the form of CFDs all your eggs are in one basket, but you have all sorts of different eggs so you are, essentially, ‘hedging’ your trades within the ETF.
A hedge is a trade that is aimed to reduce the risk of extreme price movements in a specific instrument. Usually, this is achieved by taking an offset position in a related instrument, or opening ‘short’ and ‘long’ deals simultaneously.
Okay, now that we’ve got that covered, let’s understand how ETFs allow traders to hedge. For example, if you only trade Facebook share CFDs exclusively, your results are entirely dependent on Facebook’s success – or failure. But if you’d like to hedge, you can trade share CFDs of other tech giants – IBM, Apple, Microsoft and Google - giving you a variety of instruments in one trade. This is the main function of an exchange traded fund (ETF).
Want another example? Sure…
Let’s suppose you want to invest in gold. But you’re not entirely sure which gold mining company is the best one to invest in. With a gold ETF, you can invest in a whole bunch of gold mining companies in one, single trade. That way, if one company goes bankrupt due to poor management or any other reason, you still have fourteen more companies in your ETF to potentially get returns on.
Note: On top of major indices and industries, ETFs can also track the economic performance of entire countries.
How do you create an ETF? Well, you don’t – banks do. ETFs are usually presented by banks in the form of a detailed plan to the Security and Exchange Commission (SEC) with an explanation of how the fund will be created, as well as what instruments will be included in it. If it’s approved, the bank that created the ETF will contact firms that own the shares included in the ETF. Then, the shares are amassed and sent to a custodial bank and the ETF is created at an equal value of the instruments collectively. At this point, the firms involved could sell the shares at the same price of the underlying shares in the ETF. However, much like with any other CFD instrument, ETF traders can potentially gain on their investment by exploiting the buy and sell price differences of the same securities in the fund.
There are many types of ETFs. For example, a Nifty ETF will include the 50 stocks comprising the Nifty 50 (India’s National Stock Exchange).
Now that you’ve had some background information, let’s get started on some of the more practical applications of the ETF.
A mutual fund is a financial instrument whereby a collection of funds from several different traders is pooled together to invest in securities like stocks, commodities or bonds.
Mutual funds and ETFs are each tradable instruments that can help diversify your portfolio. So, what is the difference between the two? Well, let’s look a bit closer. An ETF is a security that mirrors an index, a commodity, or a combination of assets such as an index fund but trades similar to a stock on an exchange.
An index fund is a kind of mutual fund but tracks indices exclusively.
Another difference between ETFs and mutual funds is that ETFs are supposed to mimic a benchmark like the S&P 500, whereas mutual funds are intended to beat a benchmark. That means that those managing the mutual funds will try to outperform an index like the S&P 500 by opening trades on securities within a said index but are unrelated to what’s actually happening in the index itself. This requires a lot of research and decision making. ETFs essentially mimic a benchmark on autopilot. That is the reason why ETFs, which are not as closely managed, incur lower fees than mutual funds. Keep in mind though that when you trade ETFs in the form of CFDs, management fees are non-existent.
Chart of Gold Trust ETF
As previously mentioned, an index fund is a kind of mutual fund but tracks indices exclusively.
Both ETFs and index funds have their own unique strengths when it comes to tracking an index. Index funds renew their balance (or ‘rebalance’) on a daily basis to readjust their bid and ask spreads on the underlying trades. These transactions do not apply to ETF traders since they create a basket of tradable instruments with some sort of common denominator (i.e. gold stocks etc.). This process is called a ‘creation/redemption in kind’.
Index funds - on the other hand - have something called a cash drag which is the time lapse between the fund receiving the dividend and the time until it uses the proceeds. ETFs also have cash drag but at a much lower level.
However, unlike ETFs, index funds reinvest cash dividends instantly. Because ETFs are a trust fund in nature, cash dividends can only be given to shareholders at the end of a quarter. Again, ETFs also have lower management fees even though shareholder transaction fees are virtually nonexistent for index funds. ETFs on the other hand, compel the trader to pay the bid/ask spread and - in some instances - commission.
If we made you think that ETFs were all about shares, this isn’t always the case. One example of an ETF that deals with other instruments is a commodity ETF, which trades material commodities, like agricultural goods such as corn, coffee or sugar, natural resources such as oil and gas or precious metals such as gold, metal and platinum.
A commodity ETF concentrates on a commodity like gold, oil or corn.
A commodity ETF can also be used to track the performance of a commodity index that can involve tens of underlying commodities using a mixture of physical storage and derivative positions.
Commodity ETFs are popular among traders who favor commodity trading over other tradable instruments.
Chart of US dividends ETF
Imagine if you traded an ETF and profited every time the underlying benchmark dropped. That’s the basic definition of an inverse ETF. It’s tempting to think that an inverse ETF is equivalent to opening a short position on an ETF - the two do sound the same - but, there are some differences. For starters, short positions can be left open for days at a time, while inverse ETFs are designed for day traders who have their positions closed at the end of the day. Because inverse ETFs are opened and closed on a regular, intraday basis, the fees for holding an inverse ETF are often higher than a short position that can stay open for an extended amount of time.
Remember: Inverse ETFs and shorting ETFs may look the same, but they’re not.
In order to discuss the advantages and disadvantages of ETFs, we need to figure out what to compare them to. In this case, let’s look at regular shares, which are based on a singular, underlying instrument. The main difference is diversification. If your stock plummets, you can lose a lot of money whereas if one stock in your ETF plummets, you can limit the loss in comparison to the success of the other securities in your ETF. So by and large, an ETF can be viewed as a more conservative investment than a standalone security whereby both the risk and the reward are greater.
There’s also the matter of the required knowledge. When you trade share CFDs of a specific company, you will need to learn only about that company and the factors that impact it. With an ETF, there are a lot more factors to consider since you are essentially trading a bunch of companies at once.
Confused? Here is a quick comparison…
|
ETF CFD trading |
Share CFD trading |
|
|---|---|---|
| Number of instruments traded | A basket of instruments | One instrument |
| Risk | Viewed as lower | Viewed as higher |
| Potential reward | Viewed as lower | Viewed as higher |
| Portfolio diversification | Yes | No |
| Knowledge | Need to follow many instruments | Follow a single instrument |
So, which instrument is better? There’s no such thing. The question is simply, which instrument you prefer to trade? Each tradable CFD instrument has its own advantages and disadvantages, and you need to figure out which one is best suited to your trading goals, portfolio, preference and interests.
There are many different ways to trade ETFs. One ultra-convenient method is via CFDs. With CFDs, you can select an ETF like iShares MSCI All Country Asia ex Japan, Vanguard Total Bond Market Index Fund or the SPDR Dow Jones Industrial Average Trust (yes, ETF names are long). Simply decide if you believe the ETF’s value will rise or fall. If you're correct, you profit. If you're incorrect, you lose.
When you decide, close your deal – hopefully at the right time.
Remember: You can set up automatic exit points in your deal, like Stop Loss and Take Profit levels, the same way you would with any other CFD instrument.
Want a more thorough explanation? Check out a simple trading example.
There are various strategies traders use when dealing with ETFs. We can’t mention all of them – obviously – but we will give you a glimpse of a couple of popular options.
We hope we don’t need to tell you that these are just theories, of course. We present them here for your convenience and it’s up to you to decide if you would like to use them or not.
One strategy that complements ETF trading is the ‘Dollar-Cost Average’. With the ‘Dollar-Cost Average’ trading strategy, the trader will set aside a fixed amount of money to invest over a set period of time. Whether the asset price is high or low, the Dollar-Cost Average remains the same. This prevents making decisions based on emotion, a trap many new traders can easily fall into. It also prevents investors from injecting all of their capital into a specific instrument in one go. Instead, over time, the ‘Dollar-Cost Average’ trader will buy more contracts when prices are lower and fewer contracts will be bought when prices are higher. This - in theory - results in a lower average cost per contract.
Since the threshold for investing in a single ETF CFD is often as low as only $50, a trading strategy called the ‘Asset Allocation’ strategy can also complement ETF trading. This strategy is also a popular choice among beginners. Like the Dollar-Cost Average, asset allocation is aimed at preventing emotion from interfering with the trading strategy. How does it achieve this? By setting aside predetermined percentages to allocate on an instrument. Over time, the various percentages can be readjusted accordingly to the performance of the instruments. The ‘Asset Allocation’ strategy is used by many traders to diversify their portfolio and since ETFs are all about diversification, the two make a popular match.
Chart of Australia 200 Fund ETF
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