ETFs for the Active Trader

Synopsis:

For the
active individual investor, exchange-traded funds (ETFs) are multifaceted tools
that offer opportunities to execute sophisticated investment strategies. For
investors who prefer active trading to buy and hold, for example, ETFs may be
an appropriate alternative to individual securities because they offer targeted
yet diversified exposure. Investors may also consider trading options on ETFs
to generate immediate income and try to take advantage of anticipated swings in
market prices. Covered calls, bull call spreads, and bear put spreads are
option tactics investors might choose. Following are some other investment
strategies active traders may employ to make the most of ETFs

Short-selling and margin trading: Through short sales
and margin trading, investors use ETFs to help take advantage of short-term
changes in the overall markets.

Precious metals, commodities, and currency: Investors can gain exposure
to commodity sector stocks, gold bullion, and, within the next few years,
silver and currency markets.

Equitize a cash position: Individual investors also use ETFs as a place
to park cash while they make longer-term decisions.

Capture losses for tax purposes: ETFs may allow investors to avoid the
IRS wash-sale rule. However, the rules governing wash sales are complicated, so
before employing this strategy, investors should consult a tax advisor.

Investors exploring sophisticated ETF strategies (particularly those involving
short-selling) should consider the liquidity of the underlying securities in
the portfolio, as well as trading volumes on the ETF. In addition, although
ETFs are marketed as a cost-effective alternative to mutual fund investing,
active traders must pay commissions on each of their transactions. Frequent
trades, therefore, may negate the overall cost advantage of ETF investing over
traditional funds. Despite this risk, however, ETFs provide a new multipurpose
tool for an active trader’s toolbox.

Key Points

For the active individual investor, exchange-traded funds (ETFs) are
multifaceted tools that offer opportunities to execute sophisticated investment
strategies, such as hedging through options, short-selling, and temporarily
equitizing a cash position.1

What Is an ETF?

An ETF is similar to a mutual fund in that it offers investors the
opportunity to own shares in a broad portfolio of securities. But unlike mutual
funds, ETFs are traded throughout the day on exchanges such as the New York
Stock Exchange.

Generally, ETFs are managed to mirror the performance of a particular index,
such as the S&P 500 or the Dow Jones Industrial Average. In many cases, an
ETF manager may choose a selection of representative securities rather than the
entire spectrum of securities in the model index. Investors can find ETFs that
track not only the broader U.S. market, but also specific sectors, geographic
regions, and investment styles as well.

Shifting Focus

For investors who prefer active trading to buy and hold, ETFs may be an
appropriate alternative to individual securities because they offer targeted
yet diversified exposure. Sector rotators, for example, can find ETFs in
financial services, technology, utilities, and consumer staples. Investors
shifting focus among management style and market capitalization will find
offerings in growth, value, small-cap, mid-cap, and large-cap stocks. Tactical
asset allocators can choose among ETFs focusing in different asset classes,
including equity, fixed income, and real estate.

Hedging With Options

Option contracts on ETFs offer investors a variety of opportunities to
potentially enhance portfolio returns. A call option gives the purchaser the
right to buy ETF shares at a stated price — known as the exercise or strike
price — at any time before the option’s expiration date. By contrast, a put
option gives the purchaser the right to sell shares of an ETF at the strike
price. In each case, the option seller has an obligation to either sell (in the
case of a call) or buy (in the case of a put) shares of the ETF.

Option investors may experience a range of potential outcomes, depending on how
they expect the price of the ETF to move. By combining an option contract with
an existing position in the underlying ETF, an investor can help hedge a
portfolio against loss while maximizing return potential. Following are some
examples.

Covered Call Writing:
With this strategy, the investor owns shares of an ETF and wants to hold on to
them, but also wants to use them to generate some immediate income. She sells a
call on the ETF for which she receives cash (or a “premium”). In
return, she promises to sell her shares if the strike price is reached on or
before the expiration date. Her belief, however, is that the price will remain
unchanged during the time frame. If this is true, the call will expire
unexercised and the investor will walk away with the premium. A variant of this
strategy is to write a slightly “out-of-the-money” call. This is one
in which the strike price is only slightly higher than the current price. An
investor selling this type of call is sacrificing future upside potential in
return for current income.

Bull Call Spread:
In this case, an investor expects an increase in the price of ETF shares he is
holding and wants to try to generate extra return while limiting risk. This
investor would purchase a call at a stated price, paying the premium, while
selling another call option at a higher strike price, receiving a smaller
premium amount. If the price of the ETF shares doesn’t reach the lower strike
price on the exercise date, the investor’s loss is limited to the difference
between the two premiums. If his expectations come to fruition, then he can
purchase the additional shares when the price rises and sell them when the
price rises higher, generating additional return.

Bear Put Spread:
On the other hand, if the investor expects the price of his existing ETF
holding to decline, a bear put holding can help protect the value of the
portfolio while reducing the cost of hedging. Here, the investor purchases a
put option and then sells another put with a lower exercise price. As with the
bull call spread, the maximum loss on the option position is the difference in
the premiums paid, if the ETF price does not fall as expected. The maximum
potential gain is the difference in the strike prices. Investors may use bear
put spreads to temporarily hedge against a modest price decline; however, keep
in mind that if the ETF price falls below the lower exercise price, the gain on
the option position will not fully offset the loss on the underlying share
price.

Note that many niche ETFs may not have options linked to them, or in cases
where they do, the options may be thinly traded. Investors will want to
carefully consider whether ETF option-trading tactics are right for their
needs.

Other ETF Strategies

Following are some other investment strategies active traders may employ to
make the most of ETFs.

Short-selling and
margin trading:
Both professionals and individual investors use
ETFs to help take advantage of short-term changes in the overall markets. For
example, if an investor expects that a particular sector of the stock market
will dip due to increasing interest rates, he or she may short-sell ETF shares
that represent that market. Selling short is when an investor borrows shares to
sell, then buys them back later at a lower price, resulting in a profit. In
addition, unlike traditional mutual funds, investors who expect ETF shares to
experience an imminent rise can purchase ETF shares on margin.

Precious metals,2
commodities,3
and currency4:
Investors can gain exposure to commodity sector stocks, such as materials and
energy companies with ETFs focused on these specific areas. Today, there are
even ETFs that track the prices of gold, silver and commodities such as oil
(rather than company stocks), as well as currencies.

Equitize a cash
position:
Individual investors also use ETFs as a place to park
cash while they make longer-term decisions. ETFs track all kinds of indexes,
from low-risk government bonds to sector stocks, so investors looking for a
temporary holding place for cash should be able to find one that suits all
levels of risk and return requirements.

Capture losses for tax
purposes:
Another common strategy for ETFs is that they may
allow investors to capture losses to help defray income tax obligations without
running afoul of IRS rules. (The IRS wash rule states that investors can’t cash
out of a holding and then buy back in within 30 days.) Investors who want to
cash out mutual fund shares for a loss for write-off purposes may do so, while
maintaining a similar position in the market by simultaneously investing in a
comparable ETF. (The rules governing wash sales are complicated, so before
employing this strategy, investors should consult a tax professional.)

Considerations

Investors exploring some of these strategies (particularly those involving
short-selling) will want to consider the liquidity of the underlying securities
in the portfolio, as well as trading volumes on the ETF. In addition, although
ETFs are marketed as a cost-effective alternative to mutual funds, active
traders must pay commissions on each of their transactions. Frequent trades,
therefore, may negate the overall cost advantage of ETFs over traditional
funds. Despite this risk, however, ETFs provide a multipurpose tool for an
active trader’s toolbox.

Points to Remember

  1. For the active individual investor,
    exchange-traded funds (ETFs) are multifaceted tools that offer opportunities to
    execute sophisticated investment strategies.
  2. For investors who prefer active trading to buy
    and hold, ETFs may be an appropriate alternative to individual securities
    because they offer targeted yet diversified exposure.
  3. Investors may consider trading options on ETFs
    to generate immediate income and try to take advantage of anticipated swings in
    market prices.
  4. Other active trader strategies with ETFs
    include short-selling and margin trading; investing in precious metals and
    commodities; equitizing a cash position; and facilitating the capture of tax
    losses.
  5. Investors may want to consult a financial or
    tax professional before employing sophisticated strategies with ETFs.

Source/Disclaimer:

1“Short selling” is a strategy that involves selling
something that you do not already own. Short selling is extremely risky. Be
cautious of claims of large profits from short selling. Short selling requires
knowledge of securities markets; requires knowledge of a firm’s operations; and
may result in your paying larger commissions. Short selling on margin may
result in losses beyond your initial investment.

2Investing in the precious metals sector involves special risks,
including those related to fluctuations in the price of precious metals and
increased susceptibility to adverse economic and regulatory developments
affecting the sector. It may also be subject to the risks of currency
fluctuation and political uncertainty associated with foreign investing.

3Exposure to the commodities market may subject investors to greater
volatility as commodity-linked investments may be affected by changes in
overall market movements, commodity index volatility, changes in interest rates
or factors affecting a particular industry or commodity.

4Changes in foreign currency exchange rates will affect the value of
currency investments. Foreign investments may entail greater risks than
domestic investments due to currency exchange rates; political, diplomatic, or
economic conditions; and regulatory requirements in other countries. Financial
reporting standards in foreign countries typically are not as strict as in the
United States, and there may be less public information available about foreign
companies. These risks can increase the potential for losses.

 

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© 2011 McGraw-Hill
Financial Communications. All rights reserved.

September 2011 — This column is provided through the
Financial Planning Association, the membership organization for the financial
planning community, and is brought to you by Ronald J VanSurksum, CFP® , a
local member of FPA.

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