What Are ETFs & How to Trade Them

An exchange traded fund (ETF) is a basket of stocks or other assets that typically provides diversification compared to holding a single stock. Investors who own shares of ETFs don’t directly own the securities within the ETF. A wide range of ETFs is available across different markets such as stocks, bonds, and commodities.

ETFs track the combined performance of the fund’s securities. As such, they are pooled investment assets that provide market participants with diversified exposure to a specific market, sector, industry, bonds, commodities, and more.

While ETFs generally emulate the price of various related assets – sometimes thousands in the case of stocks – there are some that track the price of a single underlying only. For example, Index ETFs are designed to replicate and track a benchmark index, like the S&P 500. The SPDR S&P 500 ETF Trust (SPY) may be one of the most well-known examples of an index ETF. It is 1/10th the size of SPX (Standard & Poor's 500 Index). On the other hand, the SPDR Gold Trust (GLD) is an example of tracking the price of a single underlying that was designed to track the value of gold in a tenth of an ounce.

Like mutual funds, ETFs offer market participants ownership in a professionally managed, diversified portfolio of investments. But unlike mutual funds, ETF shares trade like stocks on exchanges, and can be bought or sold throughout the trading day at fluctuating prices. At tastytrade, you can trade an unlimited number of ETFs commission-free.¹

How Do ETFs Work?

ETFs are listed on centralized US exchanges where they can be bought and sold just like individual stocks. You can either speculate on their price performance or buy and hold shares. ETFs have ticker symbols just like stocks do. For example, Standard & Poor’s Depositary Receipts (SPDR) Gold Trust trades under ‘GLD’.

The price of an ETF is determined by the value of its underlying assets as well as typical price drivers like the marketplace’s supply and demand for the product.

Passive ETFs are straightforward and tend to track an index, such as the S&P 500 or NASDAQ. Active ETFs are managed, and holdings can change frequently. Some ETFs offer dividends, while others do not. Some ETFs are concentrated with a few holdings, while others are more balanced with low exposure for each ETF component. It is imperative to understand the fund you are trading or investing before diving in, as there are many differentiating factors in the ETF world.

Types of ETFs

Different types of ETFs offer diverse prospects. Explore some ETF types below.

1. Sector or Industry ETFs

Sector or industry ETFs are funds that track the average performance of a group of similar stocks. They enable you to focus on specific sectors such as energy, technology or health care. Traders and investors often use sector ETFs to capitalize on significant developments in the economy. Another use is to hedge against risk where the outlook seems to suggest a high probability of the market moving against certain industry-specific positions.

2. Bond ETFs

Bond ETFs provide diversified exposure to bonds by issuers like government treasuries, municipalities, and public or private corporations. Investors typically use bond ETFs to receive regular income payments – through interest from the holdings – as they don’t have a maturity date like individual bonds.

3. Index ETFs

Index ETFs are designed to mimic the performance of corresponding benchmark indices by having similar (if not the same) holdings as the index itself. One such example of an index ETF is the S&P 500. Index ETFs are often categorized by market cap (share price times the number of shares outstanding), where large-cap encompasses a market value above $10 billion, mid-caps between $2 billion and $10 billion, and small-caps below $2 billion.

4. Commodity ETFs

There are two main types of ETFs related to the commodity space: commodity ETFs and commodity-linked ETFs. While the former focuses on the price action of a specific commodity such as crude oil, gold, natural gas, corn, etc., the latter is in relation to companies that operate within the specific commodity sectors such as energy, metals, and agriculture. Investing in raw material ETFs can offer either narrow or broad exposure. You can choose a fund that tracks the performance of a single commodity vs. a basket of commodities.

5. Currency ETFs

Currency ETFs seek to emulate the market prices of currency pairs. Like sector ETFs, currency ETFs can potentially be used to take advantage of changes in the economy. The currency market can be used to this effect in several ways, e.g. trading based on geopolitical events or hedging against positions with risks that are related to imports and exports.

6. Blockchain & Crypto ETFs

Blockchain technology lays the foundation and infrastructure for cryptocurrencies to operate efficiently as a virtual currency. Blockchain ETFs track the performance of selections of companies with a considerable focus on blockchain technology within their operations. This thematic ETF type offers opportunities linked to the facilitation and development of how cryptocurrencies and decentralized finance (DeFi) work. Cryptocurrency ETFs track the performance of one or more digital tokens or cryptocurrencies. Unlike traditional ETFs where underlying assets are directly held, crypto ETFs can often be comprised of derivatives like crypto futures and options. Traders and investors should be aware of the volatility associated with cryptocurrencies.

7. Inverse (Short) ETFs

Inverse ETFs² are designed to generate gains when relevant stock prices decline. While commonly referred to as ETFs, technically, inverse ETFs are ETNs (exchange traded notes) that use bank debt and financing to hold short derivative contracts. So, when there is a decline in the market, an inverse ETF becomes profitable by increasing in price. Since a decline typically occurs in a bearish market, these investments are often meant for short-term trading. Traders and investors should be aware of the higher fees often associated with inverse ETFs when compared to traditional ETFs.

8. Leveraged ETFs

Leveraged ETFs³ are pooled investment vehicles that aim to mirror their underlyings’ performance and offer magnified exposure using financial derivatives. A 2x leveraged ETF, for instance, amplifies the trade or investment by using 2:1 leverage to double the exposure. Both potential profits and losses are magnified, which traders and investors should be mindful of when utilizing these products. Additionally, like inverse ETFs, fees and expense ratios are often higher in leveraged ETFs than in traditional ETFs.

9. International ETFs

In addition to the above, there are also international ETFs and country ETFs. International ETFs are typically designed to provide exposure to a particular region of the world, or a group of international companies with a similar profile. For example, the iShares China Large Cap (FXI) is composed exclusively of large-cap companies with direct exposure to the Chinese economy. On the other hand, the iShares MSCI EAFE (EFA) is composed of large and mid-cap companies operating in a variety of developed countries around the world (excluding the US and Canada).

Country ETFs, as the name implies, are unique as they offer exposure to a specific country. Some country ETFs track a specific foreign stock index, while others are designed to offer exposure to a unique investment theme within a specific country. Examples of country-specific ETFs include the iShares MSCI India ETF (INDA), the iShares MSCI South Korea ETF (EWY) and the VanEck Vietnam ETF (VNM).

Why Invest and Trade ETFs?

Trading and investing in any product is often driven by short-term and long-term financial goals, and each product comes with its own set of benefits and risks.

Benefits of Investing and Trading ETFs

When you learn about the potential benefits of trading ETFs, you likely hear about the lower volatility these products typically have relative to single-name stocks. Since these funds have spread out exposure to several different stocks, it can reduce the volatility risk of a CEO stepping down or a bad earnings announcement. Regardless of whether a surprise move in a stock is to the upside or downside, the rest of the products within the ETF tend to reduce the overall effect of the fund. Additionally, diversified ETFs further remove traders and investors from “stock picking” and the need to be right. Instead of picking a particular stock in a sector that a trader may think will go up or down, traders and investors can select a sector ETF with broad exposure to get general exposure to the entire sector.

• Diversification: exposure to several assets in one investment
• Dividends: if the fund pays them (cash dividends or dividends can be reinvested)
• Tax benefits: capital gains are only incurred when the investment is sold as opposed to throughout its lifetime, which is common when utilizing mutual funds
• Easily attainable price data and no minimum investment requirements

Risks of Investing and Trading ETFs

There are ETFs that are very concentrated to just a few stocks. In other words, a handful of stocks may make up half of the fund’s exposure—or more. In this case, these single-stock binary events can make much more of an impact on the overall ETF performance. This is why it’s important to understand the ETF’s holdings before trading or investing in a fund. This way you have an idea of what is within the fund itself, but also understand how the products are weighted. Generally, trading ETFs can be less volatile than trading single-name stocks. ETFs offer broad-based exposure to many different sectors and regions, both domestic and international. It’s important to dig into the ETF you’re trading or investing in to understand the ETF exposure and the weighting of each product within the ETF.

• Illiquid ETFs make buying and selling more difficult
• Buying and selling ETFs can be capital intensive
• Traders and investors need to be able to withstand potential market volatility
• ETFs can close or stop trading
• Traders and investors need to be mindful of added costs such as management charges and additional fees

ETFs vs. Mutual Funds: What Are the Differences?

ETFs and mutual funds differ in several ways despite being run similarly. Here are some of the key differences between ETFs and mutual funds.

Develop an ETF Trading Strategy

Developing a trading strategy is a key component to a holistic trading and investing approach. If you understand the risks, potential rewards, and implied volatility of a product, you can trade with fewer emotional reactions.

Develop a Plan for Exiting and Closing Positions

Knowing when to cut losses can be tough when dealing with a volatile situation. It’s important to have a plan for when to close or adjust a losing position. Setting up a stop order on the tastytrade platform is one way to approach this. Having a plan before a volatile event takes place helps traders and investors stay mechanical more frequently, which can help to avoid emotional reactions with positions.

Knowing when to close a profitable position can also be tough in the moment. Closing at a certain percentage of profit, at a certain price point, or a combination of both is an example of a plan for closing winners. This can be done manually or with the close at profit percent tool. The tastytrade platform also allows for setting both a stop loss and a profit target order at the same time. This is known as the bracket order system. If one order is executed, the other is canceled. Having a sound trading plan and an understanding of the tools that are available to aid the execution of your trading plan is an important aspect of trading and investing in ETFs and other products as well.

Fundamental ETF Analysis

Fundamental analysis is one of the ways you can develop a directional or neutral assumption on an ETF. Fundamental analysis is the act of combing through a company or ETF’s financial statements and other factors to establish a company or fund’s intrinsic value. From there, traders can make a bullish, bearish, or neutral assumption on how this value may change as industry factors, demand factors, and other factors play a role.

Technical ETF Analysis

Technical analysis is another way ETF traders can develop an assumption on a product. Technical analysis is the act of analyzing a product’s historical price action to develop an assumption on future price movements. Price movement and trading volume play a role in technical analysis. Whether you are using technical or fundamental analysis when deciding to trade an ETF, it is important to understand that these indicators can be incorrect as well. Having a complete trading plan is important for this reason.

ETF Trading Examples

You can buy or sell an ETF in just a few clicks on the tastytrade platform. If you click on the bid or ask price anywhere on the platform, even in a watchlist, you’ll set up an order on the trade page to buy (ask) or sell (bid) shares of stock.

Examples of Buying & Selling an ETF

Log into the tastytrade platform and then follow these steps to buy an ETF:

1. Click on a ticker symbol from a watchlist, or manually type one in where you see SPY at the top of the platform in the image below.
2. To buy an ETF, click on the Ask (Buy) price along the top of the platform, or in a watchlist if you have the ask price enabled as a column. Both ask prices are highlighted in the image below. When you click the ask price, a trade to buy 100 shares of the ETF will populate on the trade page. In this example, we are using SPY—the S&P 500 ETF.
3. Along the bottom of the trade page, you can adjust the quantity of shares, the purchase price, order type, and time-in-force (TIF) which is how long an order stays active before it expires.
4. Click the "Review & Send" button to review the trade details. On the final page, review all aspects of the order including commissions and fees and send the order.

Log into the tastytrade platform and then follow these steps to short an ETF:

1. Click on a ticker symbol from a watchlist, or manually type one in where you see SPY at the top of the platform in the image below.
2. To short an ETF, click on the Bid (Sell) price along the top of the platform, or in a watchlist if you have the ask price enabled as a column. Both bid prices are highlighted in the image below. When you click the bid price, a trade to short 100 shares of the ETF will populate on the trade page. In this example, we are using SPY—the S&P 500 ETF.
3. Along the bottom of the trade page, you can adjust the quantity of shares, the short price, order type, and time-in-force (TIF) which is how long an order stays active before it expires.
4. Click the "Review & Send" button to review the trade details. On the final page, review all aspects of the order including commissions and fees and send the order.

Buying and Selling an ETF Option Example

To trade an ETF option, first log into the tastytrade platform. Then, follow the below steps:

1. Click on a ticker symbol from a watchlist, or manually type one in where you see SPY at the top of the platform in the image below.
2. Click on the table trade view so you can see the options chain. This is where available options expirations are listed, and you can click into an expiration to see the call and put options.
3. To buy or sell an ETF option, click on the Bid (Sell) or Ask (Buy) next to the strike price of the call or put you want to trade. When you click on one of the prices, your ETF options trade will populate on the trade page. This example shows buying a 580-strike call option in SPY.
4. Along the bottom of the trade page, you adjust the quantity of options contracts, the purchase price, order type, and time-in-force (TIF) which is how long an order stays active before it expires. You can also move the strike up or down, adjust the expiration, and much more using this toolbar.
5. Click the "Review & Send" button to review the trade details. On the final page, review all aspects of the order including commissions and fees, then send the order.