How to Invest With ETFs

Exchange Traded Funds, or ETFs, are increasingly popular investment vehicles that combine the diversification of mutual funds with the liquidity of stocks. Early ETFs were primarily linked to a major stock index. Later, they were designed to mirror specific sectors. Today, actively managed ETFs give professional and nonprofessional traders alike exposure to a broad range of asset classes, including foreign stock markets, currencies, bonds and commodities.

Difficulty: Moderate

Instructions

Things You'll Need:

• Appropriately funded brokerage or trading account

Planning

1. Find the ticker symbol of the exchange traded fund, usually three letters, that provides exposure to the sector, index, currency or commodity in which you are seeking to invest. For example, to invest in silver through an ETF, purchase shares of ticker symbol SLV.

2. Before buying, savvy investors develop a plan for their investments. In the case of an ETF, there should be a reason or catalyst explaining why it should be bought and a timeframe for holding the position. An wise investor will also have a realistic target price to sell the ETF if the trade works and a "stop" level at which to sell and minimize losses. Most traders use some form of chart-based technical analysis, or real-world fundamental analysis or both for planning their purchases.

3. Buying an ETF is identical to buying a stock in most trading platforms. Usually this involves choosing a price to bid for a number of shares and entering the appropriate buy, sell, market, limit or stop order. The details of this step are specific to the brokerage, but most offer instructions and tutorials, and are willing to guide an investor over the phone if necessary.

4. Advanced and more risk-tolerant traders should check with their brokerage, or an online resource like Yahoo or Google Finance, whether an option chain is available, as some ETFs do have actively traded options. These ETFs can therefore be purchased, sold or hedged through the buying or selling of calls and puts. Options allow a trader to control shares at very low relative cost, but also carry significantly higher risk.

5. Check for execution of your trade and monitor the value of the position in your account, making sure to take profits when your targets are reached or losses if the position sinks to a pre-determined "stop loss" level.

Strategy

6. Diversification. The first and most common reason for choosing an ETF over another investment vehicle is diversification, meaning not putting all your eggs in one basket. Every company's quarterly report lists numerous realistic factors that could hurt its business and therefor its share price. In the past, traders would buy several companies in the same sector to protect against this risk. An ETF works on the same principle, with a market market buying the shares of the companies for you and then selling you a piece of that portfolio that appreciates or depreciates along with the underlying companies. Of course, since they minimize the risks associated with investing in a single company, they also generally underperform the individual leaders in a group.

7. Liquidity. If ETFs sound a lot like mutual funds, you're on the right track--both use the power of diversification to minimize risk while preserving a somewhat focused allocation that gives investors the exposures they seek. The primary difference between the two, however, is that an ETF trades on a stock exchange, which means it has real time bid and ask prices and can be bought or sold relatively quickly, just like a stock. There are no loading fees or selling fees associated with ETF investing aside from the execution fees charged by the broker that carries out your trade. This makes ETFs very easy to trade and keeps the costs of doing so transparent.

8. Timeframe. One of the most important factors in determining the viability of a trade is the length of time you're willing to hold it. Because of their liquidity, ETFs can be bought and sold on the same day, held for hours or even just minutes. However, because they rarely move by more than 1 or 2 percent per day, it usually takes a significant capital investment to make this a worthwhile endeavor. For smaller, retail investors, ETFs are usually used for swing trading, which means buying ETFs in confirmed uptrends and riding them as long as possible until the uptrend is finished. Swing traders often use specific indications within the daily and weekly price action to signal times to enter and exit.

9. Advanced traders often use ETFs creatively, such as in pairs trades, a strategy that sets one position against another. For example, by owning, or being long, the best performer in a specific market sector and selling, or being short the sector ETF, a trader can capture the relative outperformance of the market leader with minimal risk. If the sector rises, the best performer is likely to rise more than the sector as a whole, yielding a profitable trade. If the sector falls, the leader is likely to fall by less than the sector as a whole, again producing a profitable trade.

Tips & Warnings

• Always use real time quotes to get the best prices in planning and placing trades.
• Be sure to factor the broker's fees or commissions in the cost of your trade to ensure accurate profit and loss figures and the viability of a trade.
• Use Inverse ETF's to "short" a market that is falling. Some ETFs allow investors to proft from a declining market. SH is the short ETF for the S&P 500, moving up as the index moves down. Short ETFs can be used alone to place a directional bet, or as a hedge against a long position.
• Use Ultra ETFs to maximize profit potential. Ultra ETFs, either long or short, attempt to double the move in their underlying instrument. While ultra ETFs can enhance overall returns within a portfolio, they do also enhance risk, since an ultra-long ETF will sink twice as rapidly as a down market and vice versa.
• Because proceeds of ETF sales can be quickly reinvested, ETF investing can also delay payment of capital gains taxes. Consult with your accountant to determine if this applies to your situation.
• While some investors do construct long term portfolios with ETFs, most are designed as short to intermediate term trading vehicles.
• ETFs generally do not pay dividends even if the underlying companies in them do.
• ETFs are synthetic and imperfect. Contrary to the language of some marketing, ETFs attempt to “approximate” performance of their underlying components. Before using an ETF, especially a new one, investors should verify for themselves its relative performance.
• Discerning investors will want to examine an ETF's composition before buying. Some, like the FXI, an ETF tracking the Chinese stock market, is heavily concentrated in only a few companies, which does not minimize company-specific risk.
• ETFs can be actively or passively managed. In active management, a fund manager makes trading decisions that can greatly effect the overall performance of the ETF. Investors may want to consider the record and experience of the fund manager before investing in an actively-managed ETF.
• Some commodity-based ETFs assess a fee for storage or maintenance of the underlying commodity that is not charged to shareholders directly, but which can gradually dilute the value of shares. Commodity ETFs are not redeemable for actual goods.
• As with all investment decisions, using ETFs should be done carefully and with significant consideration. Before placing an order to buy or sell, an ETF investor should have a clear goal for the position, a timeframe for realizing this goal and a stop level where the position will be unwound at a minimal loss.

Resources

• Motley Fool ETF Guide
• ETF Strategies
• View ETFs