Why Do Traders Invest in ETF Price Movements?

Exchange-traded funds (ETFs) are stock-like products that trade on exchanges. The first ETF was the launch of Index Participation Shares for the S&P 500 in 1989. As of 2020, there were more than 7,600 ETFs actively traded.  There are various reasons that you might trade an ETF, as the exposure you can achieve from trading these products can be unique. Not only can you use an ETF to initiate a new type of position, but you can also use an ETF for risk management. There is a wide variety of trading strategies that you can use when you trade ETFs, including technical analysis and pair trading. You can also use ETFs to diversify your portfolio.

What is an ETF?

An exchange-traded fund (ETF) is a security that tracks the movements of a group of assets. These assets could be a stock sector or an index. It can be a single commodity or a group of commodities. It can also be a currency pair or a currency index. An ETF can be constructed to track the movements of any product, but it can also be structured to track specific investment strategies. For example, there are passive ETFs that follow the direction of an underlying asset, and there are ETFs that focus on active trading strategies.

The term exchange-traded fund means that the asset is traded on an exchange like a stock. The price of the shares will fluctuate intra-day like a stock, based on market sentiment. The intra-day movement of an ETF  is unlike mutual funds, which trade only once per day after the markets close. Additionally, ETFs tend to be cost-effective and very liquid.

What Trading Strategies Can You Use with an ETF

ETFs offer a wide range of products, which some traders find appealing to use for trading strategies. Whether you plan to track an index or use a moving average crossover strategy to follow a basket of commodities, ETFs provide excellent liquidity in most circumstances.

Most of the ETFs are offered passively traded ETFs. These products track the movement of an underlying index. The managers of the ETF do not use discretion, and their only goal is to follow another product.

There are also active ETFs, where an investment manager is actively managing a portfolio of securities. Many ETFs are managed mutual fund companies that want to provide an alternative to a mutual fund strategy.

You can also use ETFs to take positions in sectors of stocks that are more challenging to manage individually. For example, if you were interested in taking a position in financial stocks, you could considertrading an ETF like XLF (the Financial SPDR ETF). This ETF tracks dozens of banks, brokers and insurance companies to generate exposure to the financial sector. Some ETFs track the energy sector, the materials sector, and every sector in the S&P 500 index. You might be looking for exposure only to one sector or many. You might also be bullish on the direction of one sector and bearish on the path of another industry.

This strategy is called pair trading. ETFs can allow you to offset your directional risk with basis risk. For example, instead of speculating that the S&P 500 index is moving higher, you instead bet that the financial sector will outperform the energy sector. You can do this by purchasing trading an ETF that tracks the movements of the financial industry and simultaneously short the ETF that tracks the energy sector.

You generate pairs from sectors as well as indices. For example, you can open a ‘Buy’ deal on a US index ETF and simultaneously a ‘Sell’ deal on a Japanese index ETF. The number of pair trades that you can transact using ETFs is infinite. Many traders use a mean-reverting strategy to trade ETF pairs.

Can You Use Leverage to Trade ETFs

Many brokers will offer both options and CFDs that track the movements of ETFs. ETFs on the exchange are subject to the leverage offered by rules dictated by the exchange regulators. CFDs that track the movements of ETFs can offer different levels of leverage which depends on each broker.

The Bottom Line

The upshot is that ETFs are financial instruments that you can use to create trading strategies. You can also use ETFs to hedge your risk. ETFs are financial instruments that track an underlying asset or multiple assets. These can be anything from an index of stocks to an individual commodity. You can create an ETF to track any asset. The term ETF means exchange-traded fund and generally trade on a regulated exchange. You can trade ETFs that track the movement of an underlying asset a trading strategy. The upshot is that ETFs are liquid assets that have many investors find optimal for their trading goals.