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What Traders and Investors Need to Know When Using ETFs

Exchange-traded funds have become enormously popular among the investment community in recent years. The number of these financial vehicles continue to grow as well, and with that trend comes more

Exchange-traded funds have become enormously popular among the investment community in recent years. The number of these financial vehicles continue to grow as well, and with that trend comes more complexities to how they can be used by investors and traders alike.

Total assets under management in U.S. ETFs alone are up by $115 billion so far this year, outpacing mutual funds by a wide margin. Though ETFs provide many benefits and advantages to playing the market, like any financial instrument, investors and traders need to fully understand what they’re buying and selling to minimize risks.

Toni Turner of TrendStar Trading Group discusses more on how ETFs can offer unique opportunities for profits as well as a few of her own winning strategies.

EQ: What are the biggest advantages to trading ETFs that are not available in trading individual stocks or mutual funds?

Turner: Exchange-traded funds actually have many benefits over mutual funds. Many ETFs have lower operating costs than mutual funds, and that’s an advantage, because that money goes into our pockets. Of course, unlike mutual funds, ETFs can be bought and sold all during each trading day. That’s in contrast to mutual funds, which can only be sold for the closing price at the end of the day.

Another nice benefit of exchange-traded funds is that you pay taxes according to the profit or loss that you make when you sell the fund instead of getting taxed on profits at the end of each year, as you do with mutual funds.

For traders, the benefit to trading ETFs versus single stocks, comes with the reduction of time spent on research. For example, if you know that the semiconductor industry is doing well, instead of going through all the stocks in the semiconductor index, you can buy a semiconductor ETF like the iShares PHLX SOX Semiconductor Sector Index Fund (SOXX). This way, you don’t have to research each and every stock.

EQ: How can traders and investors use ETFs in their strategies to be successful in the market?

Turner: If we’re talking strictly equities ETFs, since each share of an exchange traded fund is naturally diversified, it takes some of the volatility out of a trade, and sometimes that is a very pleasant thing. Of course, there are many different indexes that ETFs seek to replicate. But let’s say you’re trading in the biotech industry group, which is, of course, an industry group under the Healthcare sector. We all know that biotech stocks can be very high reward, but the risk can be extreme. I remember waking up one morning to find that a biotech stock position I owned had fallen five points. That is what we would call a rude awakening!

Now, though, instead of trading individual biotech stocks, there are two major ETFs that serve well if you want to target the biotech industry group: the SPDR S&P Biotech (XBI) and iShares NASDAQ Biotechnology (IBB). Focusing on these ETFs allows investors and traders to gain the rewards of the group without facing the risk of a single stock gapping down. With ETFs, one component stock having a bad day will not take down the index.

EQ: Leveraged and inverse ETFs have gained a lot of popularity among traders in recent years. What are some things that longer-term investors should be aware of when looking at these financial instruments?

Turner: Traders, and certainly investors, should not enter leveraged and inverse ETFs without having a thorough understanding of how they work. Because of the way that they are configured, these kinds of ETFs are only meant to be held for one to a few trading days. After that, because of the way they’re calculated, they can tend to lose steam and will not necessarily follow the underlying index exactly. Let me just say that holding leveraged inverse ETFs for a long period of time is not a good idea. They’re not constructed to be used that way. They are good short-term trading and hedging vehicles.

EQ: So what are some of your favorite ETF setups to look for when you trade?

Turner: In Toni’s Market Club, we have a setup that we use called “the sleeping tiger.” It’s a combination of moving averages, momentum indicators, and the average true range. We use that quite a bit when trading ETFs. You can trade ETFs using simple moving averages like the 20-day SMA, 50-day, and 200-day, plus a momentum indicator or two, and simply buy and sell using that kind of criteria.

Another one of my favorite strategies to use for trading ETFs, especially in an uptrending market like the one we are experiencing , is to use a traditional equities sector ETF that reacts well to bull markets. So maybe it’s Basic Materials, Industrials, or Energy. Typically, I use iShares and Sector SPDRs funds quite a bit because these two families of funds have the most volume. I prefer funds that trade over 400,000 shares average daily volume. So, I put on a sector ETF that works well in bull markets and I just hold it as a position trade, then I take one of the best stock components in that ETF and swing trade that to juice the profits.

EQ: Can you talk a little bit more about your Sector Strategies?

Turner: It’s important for traders and investors to know which sectors work well in bull markets and which sectors do better in bear markets, or even in pullbacks or retracements. I watch the Utilities sector a lot. It sometimes forecasts if the the market is worried, or not. March 12 showed a pretty graphic rendition of that. The Utilities SPDR (XLU) popped higher when the market felt uncertain. Utilities are a defensive sector, and when investors feel uncertainty in the air, the XLU may move up. The XLU doesn’t usually trend often. It usually consolidates until it has a really good reason to move up or move down. When investors are not worried, the XLU may fall, as was the case toward the end of last week. In rising markets, Utilities simply are not whizzy enough for momentum players. So sometimes if you’re quick, you can take advantage of those kinds of moves.

You can do very well trading and investing in sector ETFs if you keep in mind which sectors thrive and which sectors dive in both bull and bear markets. Once you understand the basics of sector rotation, you can move between them in both short-term and long-term positions. And, this knowledge can definitely give you an edge.

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