Options Explained, in Kid Language

A Call Option is:

Ted is visiting Jimmy and notices a nice baseball card.

Ted: “That’s a nice baseball card! What is it worth?”

Jimmy: “About $10 right now!”

Ted: “Dude, I bet it’s gonna be worth $20 by the end of the year!”

Jimmy: “Really? I don’t think so. Wanna buy it from me?”

Ted: “Yes, but I don’t have $10 right now. All I got is this one dollar bill.”

Jimmy: “Tell you what: I’ll take that $1, and from now on until the end of the year, I’ll sell you that card for $10. Just hit me up whenever you get the money.”

Jimmy just wrote a call option for $1 at a $10 strike price to Ted.

Months go by. Ted just can’t get that $10 together to buy the card. He notices the card’s value is now up to $15. He tells his brother: “Hey, so Jimmy is gonna sell me that baseball card for $10, but it’s now worth $15, and still going up. Thing is, I don’t have the money to buy it. Can you give me $5.50 (since the call is now $5 “in the money” and guaranteed to be worth at least that much, but the card’s value can still go higher), and I’ll sell you that option?” So his brother gives him $5.50. Ted bought a call at $1, and sold it at $5.50, for a cool 450% return, without ever touching the card itself and risking very little money.

By December, the card is now worth $18. On New Year’s Eve, Ted’s brother stops by Jimmy’s house, hands him $10, then drives to the card shop and sells the card for $18. He executes the option, for a gain of $18 – $10 – $5.50 = $2.50, still a 45% return on his $5.50 investment.

Jimmy is kicking himself in the butt, because he didn’t believe that his card had that much potential. But at least he got a dollar “profit” out of the deal, without even doing anything. If the price of the card had stayed at $10 or below, he would have kept the card, and the $1 Ted gave him.

A Put Option is:

Ted is visiting Jimmy and notices a nice baseball card.

Ted: “Woah, I need this for my collection! Are you selling it? I’ll give you $10 for it!”

Jimmy: “Yeah, I’m not really attached to it and would totally sell it, but it’s worth $20 right now. And I don’t wanna get shortchanged, you know.”

Ted: “$20? That’s nuts! It’s worth $10, max!”

Jimmy: “You might get lucky soon. I heard rumors that they’re reprinting it, and then it’ll drop to basically zero. I’m actually a little worried about this, but not worried enough to sell it for $10.”

Ted: “No way that they’re gonna reprint this! Even if they do, it’s not gonna drop much below $10. Let’s do this then: Until the end of the year, you can call me anytime, and I’ll buy the card from you for $10, no matter what it’s worth. But in return, you give me $1 now up front, to compensate for the risk I’m taking on and because I need to keep the $10 handy. But if I don’t get a call from you when the year is over, I’m gonna keep that dollar.”

Ted just wrote a put option, strike price $10, and sold it to Jimmy for $1. Jimmy is happy, because even if the card is being reprinted, he still gets $10 for his card, guaranteed. He basically bought insurance against the price drop. Ted is happy, because he got a “free” dollar, and he may get the card for $10, the price he was initially willing to pay anyway.


Deep-in-the-money ETF Options?

Exchange Traded Funds (ETF) such as QQQQ, SPY, IWM and DIA all have a broad representation of the stock market, and so tend to be more stable and less volatile than individual stocks. They tend to settle into a trend, and hold it for longer, whereas stocks tend to bounce around all over the place. This inherent stability provides an opportunity for options traders, especially for those who are not after the huge gains, but are happy to trade more frequently for smaller bites of the cheese. Selling credit spreads is an excellent strategy for taking advantage of a trend, and making 10% per month on a portfolio. Another excellent strategy is to use Deep-in-the-money (DITM) options.

DITM options have a relatively high Delta, which means that when the stock price moves by $1, the related option price moves by a similar amount. This means that the maximum amount of movement in a stock’s price can be captured using the leverage of an option trade.

The basic strategy for trading an ETF (for example, QQQQ) is similar to that of swing trading. You are aiming for small gains in short times, and most trades will be completed within 1-2 days. The technical analysis requirements for a trade of this strategy are not onerous – in fact it is easy to over analyse, and end up not having the courage to make a trade. In essence, you need to know how to identify a trend, and to be able to give a measure to the strength of the trend. You also need to be able to pick up the likelihood of an imminent trend reversal, by identifying support and resistance lines. If the trend is upward, you will buy DITM calls; if downward, but DITM puts.

The best option to pick is one that has a Delta between 70 and 90. This is so that you are not buying the most expensive options, but you are still going to capture the movement of the stock as much as possible. You also need to pick an option that is about two months from expiry, so that time decay does not have too drastic an effect. In any case, you will be in and out of the trade so quickly that time decay should not be significant. Set an entry for the trade somewhere near the lower end of the daily trading range, or wait for a one or two day pull back before entering.

As soon as you have entered the trade, the first and most important step is to set up a stop loss. Only stupid and irresponsible traders work without stop losses, especially when dealing with options. The first rule of options trading is to minimise your losses! Having done that, set up an exit trade of about 12-15% profit. Quite often this will be filled within a day or two, which means that you get to do another trade.

Trading DITM options on ETFs such as the QQQQ is an incredibly good and relatively easy strategy to generate regular profits. The time requirements are not too demanding, and the process can be somewhat automated.

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When people ask for investing advice, ETFs usually come up pretty quickly, because they are so heavily marketed and trumped by the industry. Exchange-traded funds, or ETFs, are an easy way to diversify a small investment, but to get the most out of your investment, it is important to understand how they operate.

ETFs are like mutual funds, in that they are a collection of investments, but they are traded on an exchange, such as the NYSE, instead of purchased directly from the issuing company. They also differ in their redemption structure and tax efficiency from traditional mutual funds.

Here are five benefits of ETFs over mutual funds:

1. Tax Efficiency: Upon redemption, mutual funds must sell its underlying securities, and the capital gains are then distributed to the owners of the funds. Since ETFs trade on an exchange and investors are selling to other investors, no underlying securities are sold, and no capital gains are distributed. If the makeup of the ETF changes it will, occasionally have to distribute gains, but it should be less frequent than with traditional mutual funds.

2. Lower Fees: ETFs are no-load funds, and you won’t be slapped with a redemption fee when it’s time to liquidate your position. Further, ETFs typically have lower annual fees than traditional Mutual Funds, making them an attractive alternative. (NOTE: In rare cases where a very small amount is being traded, broker’s fees may be a higher percentage of the investment than a mutual fund’s expenses would be, but in most of these cases the invested amount would not meet the minimum investment required by most mutual funds).

3. Liquidity: The exchange-traded structure of ETFs generally allow for liquidation of a position faster than a mutual fund, which must be liquidated at end of day. Further, the ability to set a limit order allows flexible trading that no investor could get from a mutual fund. Not all ETFs have the same liquidity, however, and it is important to review trading volumes and the ETF prospectus to determine whether you are comfortable with the frequency of trades.

4. Intraday Pricing: Because ETFs are traded on active stock exchanges, purchases and sales happen at market prices, rather than end-of-day Net Asset Value, which mutual funds use. As a result, one may purchase ETFs at a premium or a discount to the value of the underlying assets, and arbitrage is frequent.

5. No Minimum Investment: When starting investing, diversification can be cost prohibitive if you’re using traditional mutual funds, which frequently have a minimum investment of $2500 or more. Because ETFs have no minimum investment (other than the market price of one share), they are a good vehicle for diversified investing.

Of course, many of these benefits could be liabilities if not used properly. For instance, the intraday pricing feature of ETFs could lead an investor to buy an ETF at a premium or sell it at a discount to the value of the underlying securities. Also, brokerage fees may have a greater impact on some investors than traditional mutual funds’ management fees and loads would have.

Used wisely, ETFs can be a good vehicle for widely diversifying a small or initial investment, but it is always best to seek professional investing advice.

8 Rules for Success with ETFs

Managing a global portfolio of exchange-traded funds (ETFs) is a great way to build a diversified portfolio with exposure to equities around the globe. Fortunately, you need not be a rocket scientist to do this, but many investors fail to observe some basic guidelines, and it can get them into real trouble. Follow these eight steps and sleep easier.

1. Liquidity Comes First: Before you even think of building an investment portfolio, you should set aside about six months of income in a “rainy day” account. This could be put into a money market fund or U.S. Treasury securities. Having this money set aside will ease your mind and allow you to be more open and creative with your global portfolios.

2. Separate Portfolios: You should separate your core conservative portfolio from your growth portfolios. With the core conservative portfolio, your top priority is capital preservation, and growth is a secondary consideration. Your growth portfolios are more speculative, with capital growth as the primary goal.

3. Really Diversify Your Portfolios: You need positions in your portfolios that are likely to offset each other as unexpected events and market movements become a reality. This is not accomplished with different sectors of ETFs or a mix of small-cap, mid-cap and large-cap ETFs. Rather the goal is to have some investments that are on both sides of risks.

For example, if the U.S. dollar declines, have some investments in precious metals or denominated in other currencies, such as Switzerland or Australia or Singapore ETFs. If inflation heats up, have some investments that hedge this risk such as timber, gold or Treasury inflation-protected bonds (TIPs). If political events or policies in one country take a turn for the worst, it is helpful to have investments in other well-developed countries to offset any loss of value. You get the idea, spread your risk and avoid having one ETF account for more than 5%-10% of your core portfolio.

4. Be Careful Which Countries You Pick: You need some guidelines to help keep you from getting carried away and having too concentrated a position in a particular country or region. In particular, take a good look at the following: 1) the stability and overall political and corporate governance; 2) the legal environment, respect for contracts, low levels of corruption, due process and rule of law; 3) the macroeconomic environment including fiscal discipline and currency strength; and 4) political risks that could affect financial markets.

Keep in mind that the quality of the countries you choose to invest in is the primary but not the only factor. The price or valuation of a country’s stock market is also extremely important. Oftentimes, the best time to buy into a country’s stock market is when it is beaten down, but there are signs that its economic and political problems will sharply improve. If you have a long-term perspective, you might consider annuities specially structured for ETF portfolios.

5. Minimize Company Risk by using our “buy countries, not stocks” strategy. Instead of trying to pick the best three stocks on the Tokyo Stock Exchange, why not just minimize company risk by buying the iShares MSCI Japan Index, which tracks the Nikkei 225 and spreads this risk across 225 Japanese companies.

6. Monitor ETF Country And Company Exposure: Be careful to look under the hood of ETFs to see where your money is going. For example, let’s look at the iShares MSCI Emerging Markets ETF. It invests in 26 different countries, so it is natural to think that you will get broad exposure to all 26 countries. You would be wrong: 50% of your investment in this fund is going to four countries: South Korea, South Africa, Taiwan and China. In addition, incredibly, 7.5% is going to one company, Samsung Electronics of South Korea.

The same is true for the MSCI Europe, Asia and Far East index. It contains 21 developed countries, but 48% of the money you invest would go to just two: Japan and the United Kingdom. Meanwhile, less than 1% would go to Singapore and Ireland! Country specific ETFs such as the new iShares FTSE/Xinhua China 25 Index can also have a fair amount of concentrated risk. Although the China ETF tracks a basket of 25 companies, the largest five companies account for nearly 50% of your exposure.

7. Cut Losses With A Trailing Stop-Loss Policy And ETF Put Options: We have all been there. You buy a stock or fund, and it appreciates in value rapidly. Then it stumbles and begins to decline. What do you do? Should you buy more, let it ride, or sell? Save yourself a lot of pain and agony by following a simple rule. If a position ever falls more than 20% from its high, sell it immediately and reassess the situation. If you invest in an ETF with a sizable downside risk, why not spend a few hundred dollars to purchase a put-option as an insurance policy?

8. Rebalance Your Portfolio: At least annually, you need to make some changes so that you are not overly exposed to countries that have higher risk factors and volatility. One way is by selling some shares of your winners and increasing exposure to under performers. This accomplishes another goal, locking in gains and taking some money off the table. Remember, only a fool holds out for top dollar, especially in the more volatile emerging market countries.

Building your portfolios with low-cost, tax-efficient ETFs is a smart strategy, but don’t set it on auto pilot.

The ETF Parade

Riding the wave of investor appetite for commodities, currencies and precious metals, the makers of exchange-traded funds (ETFs) continue to find new ways to slice and dice the market.

The instruments continue to proliferate and pull in money. In the last decade, assets under management at ETFs have soared 59% to $627.4 billion, according to research firm Morningstar Inc. Asset growth has slowed a bit recently, to just under 40% over the last three years, as the industry has gained a more substantial base.

But the massive asset gains have begun to slow slightly. Meanwhile, the number of new funds has grown. The last decade saw the number of new ETFs rise by 39.1%; over the past three years, that ramped up by 52.5%. Much of those gains were in 2006 and 2007, with that pace finally slackening this year as the markets became more unpredictable. (There were 787 ETFs based in the United States as of May 31, according to Morningstar.)

Issuers of the products “are less willing to do new issues,” says Kevin Farragher, managing director of Rydex’s ETF business line. He notes that fewer offerings have launched so far in 2008 than over the same period last year partly due to market saturation, as the most obvious market indices already have several products tracking them, and even the most mundane have at least one.

But Farragher also blames the fact that “there’s less seed capital to be had.” Traditionally, an issuer launched an ETF by getting money to start the fund from Wall Street firms known as authorized participants. The ETF issuer would give the firms shares in the ETF. And the institutions would act like a syndicate in an equity offering, selling the ETF shares from their inventories into the market.

Partly in reaction to their own financial circumstances, they are less willing to do new issues. “They want to do things that will be successful,” Farragher says. “There’s pressure on the issuers to be more judicious in choosing a benchmark around which to build.”

Nonetheless, the industry continues to crank out new products. As of May 31, there have been 131 new ETFs this year, or 16.6% of the 787 U.S.-based funds.

He said he expects the pace to slacken over the summer and for new issuance to slow in the coming year. Regarding the new issues this year, he says, “You’re not seeing the acceleration in new issues you saw the two or three preceding years. It’s holding flat. That’s because people are delivering on their 2008 plans as opposed to all of these new opportunities being discovered and acted upon quickly.”

The development has come from issuers creating even more specific instruments, from broad indices to specific market caps. Jeff Ptak, ETF analyst at Morningstar, cites this as the continuation of a trend toward more specific exposures to sectors and industries.

For example, there are some products in registration that give investors exposure to real estate in general and the housing market in particular.

Other ETFs track individual countries and geographic regions. Consider the recently launched ETF from Invesco PowerShares, called the MENA Frontier Countries Portfolio (ticker symbol: PMNA).

It’s based on the Nasdaq OMX Middle East North Africa Index, which is designed to measure the performance of the largest companies in the Middle Eastern and North African countries of Egypt, Morocco, Oman, Lebanon, Jordan, Kuwait, Bahrain, Qatar and the United Arab Emirates.

The index has 67 companies with market capitalizations between $243 million and $10.4 billion.

Bulls and Bears 

The areas that have seen the largest increase in interest are leveraged and inverse ETFs. These funds seek to give the investor bearish and bullish exposure to an index.

According to Morningstar, there are 77 leveraged and inverse ETFs, all based in the United States, holding $17.5 billion as of May 31. That outpaces the growth of the ETF industry overall, something Ptak describes as “no mean feat.”

He cites ProShares as one of the more successful managers when it comes to gathering new assets. One of the company’s popular strategies-on the positive side-has been the Ultra QQQ (which tracks the Nasdaq). But given the poorly performing markets, there have been many more bear hits lately: UltraShort S&P 500, UltraShort Oil and Gas, UltraShort Financials, and UltraShort Russell2000. In these cases, the ETF holder is betting on getting twice the inverse of the daily index return. So if the S&P 500 index loses 2%, the fund aims to deliver 4% on the day.

Gary Stroik, chief investment officer at WBI Investments in Little Silver, N.J., chairs his firm’s investment committee and uses mostly individual securities and ETFs. He likes ETFs for giving advisors access to tools that would otherwise be unavailable to the typical client in his $275 million practice, like commodities. “You could invest in Exxon-but not oil,” Stroik says. “You could invest in Newmont Mining-but not in gold. It’s a powerful tool, but like other powerful tools, you’ve got to be careful how you use it. It’s a chainsaw,” he says, alluding to the leveraged ETFs that give an investor double the exposure to a particular index or sector. He uses the term “double exposure funds” to describe them and says they can be dangerous.

For example, say an investor wants a $10,000 exposure to the S&P 500. He could could buy $5,000 worth of a double-exposure ETF, and safely stash the other half in a Treasury bill or money market fund. “I get a return in the case, get the same portfolio exposure and performance I wanted, and pocket the interest on the cash,” Stroik says. “On the other hand, if you put the entire $10,000 into the double exposure fund, you’d get twice the risk exposure and no cash cushion.”

Ptak says these ETFs are handy for making a bearish bet because of their ability to spread risk. “When you look at the risk-reward profile on a particular stock, and contrast that with the risk profile of shorting a basket of stocks, the latter choice is better,” he says. “You sacrifice some upside, but you spread uncertainty across lots of stocks.” Ptak points out that, unlike the old method of shorting-borrowing money from your broker on a margin account, which could lead to unlimited losses-the downside with bearish ETFs is limited to the investment in the ETF. “It’s a better mousetrap,” he says.

In addition, these products are especially useful when credit markets tighten. “Hedge funds in particular have taken a shine to these leveraged products because these ETFs will be there whether banks are lending or not,” Ptak says. A hedge fund manager can get 200% exposure to a particular index quickly and easily by buying a leveraged ETF, without drawing down a line of credit with their bank, or worrying about a margin call. It also saves the hedge fund manager from worrying about a nervous banker calling in all of the fund’s lines of credit when the bond markets start clamping down.

This is how it works. The typical ProShares ETF enters into a total return swap contract. The ProShares trust agrees to pay LIBOR (London Interbank Offered Rate) or a Treasury bill return plus some extra amount in exchange for the return of a specified index (or twice the return of a specified index).

Analysts are watching for growth from a new breed of complex derivative-style products that allow investors to buy risk. As yet still in the regulatory pipeline, these esoteric products would allow investors to access strategies previously available only to institutional investors. These risk-exposure products would be similar to credit default swaps (CDS), a sophisticated derivative instrument that gives the buyer a pure exposure to a company’s credit risk.

Buying a CDS differs from simply owning a corporate bond, which also exposes the investor to interest-rate risk, curve risk and prepayment risk. Credit default swaps have been popular with institutional investors for the investment precision they offered when constructing a portfolio. However, the CDS market was also hit hard in the painful credit crunch of last summer.

Little-known fund advisor CCM Partners has filed to manage four such ETF-like structures called ETSpreads, which will aim to track indices that are essentially baskets of CDS: a high-yield bond index and its inverse, and an investment-grade bond index and its inverse. These types of risk products would be most useful to the more sophisticated advisors with high-net-worth clients, such as corporate executives with large blocs of stock in their employer. Such clients have portfolios that are both large and complex enough to warrant precise removal of risk from certain stocks.

Similarly, there are other ETFs in registration aiming to zero in on very specific risks. Earlier this year, MacroShares registered a pair of products tied to the housing market: MacroShares Major Metro Housing Up and MacroShares Major Metro Housing Down. “These are large economic exposures that consumers and investors have day in and day out,” Ptak says.

Instead of providing an indirect exposure to a specific risk, products like MacroShares attempt to focus on the risk with pinpoint precision. “We’re getting much more narrowly focused niche-type products, in which ETFs divvy up risks and exposures into ever-thinner slices,” Ptak says.

Indeed, the same company also has a pair of ETFs in registration that give the investor exposure to the risk of medical price inflation. The MacroShares Medical Inflation Up Shares and MacroShares Medical Inflation Down Shares, its bearish sister, will track the medical care component of the Consumer Price Index. This strategy allows investors a great degree of precision, in case they want to take a strong stand on a particular industry. If you thought medical inflation would go up, before these ETFs, the natural bet would be to buy shares in an index holding the big pharmaceutical stocks, or an actively managed sector fund, or an ETF such as the Vanguard Health Care ETF. But often those indices hold extraneous companies. Plus, there are other influences between consumers and inflation, such as the company. With the new structure, the investor does not have to think about what’s going on in the company, only medical inflation.

MacroShares already has a pair of funds that do the same for oil prices, but they are being closed down. They were created with a kind of self-destruct mechanism that triggered a termination clause when the price of oil hit $120 a barrel. The company is liquidating the funds by giving a cash redemption to investors, similar to mutual fund liquidations.

Hitting the Right Note

Meanwhile, exchange-traded notes continue to be much discussed because of their advantageous tax status. But the Internal Revenue Service still may remove that beneficial tax treatment at some point in the future. (The agency has already removed the tax breaks from one specific type of ETN; those tracking single currencies.)

For a non-single-currency ETN, the only taxable event for an investor is when the note is redeemed. If the investor sells after a year, there are only 15% capital gains. Compare that with an ETF, which sees 60% of its gains taxed at long-term rates and 40% taxed at short-term rates. Those taxes get passed on to the investor regardless of how long he held the ETF.

Regardless of how the IRS rules, though, ETNs are still a very efficient way to own currently hot asset classes like commodities and currencies that were difficult to own before. Part of the reason for their efficiency is their structure.

They are notes, or debt instruments, which are tied to the performance of a particular benchmark, rather than a trust that holds a basket of securities, as with an ETF. As in a traditional bond, the issuer of an ETN promises to pay the investor that index return. That means all the investor has to worry about is the credit risk of the issuing bank. And because one of the biggest issuers of these new instruments is banking giant Barclays, Ptak regards the credit risk aspect of many ETNs as fairly safe.

What investors do not have to worry about is the transaction costs within the ETN, as compared to an ETF in which managers buy and sell securities. So the ETN structure eliminates two of the main problems with investing in commodities, currencies and precious metals: transaction costs and tracking error.

But, investors should note that ETNs are not as cheap as the cheapest ETFs. The median expense ratio on ETNs is 75 basis points. The cheapest tracked by Morningstar costs 30 basis points, and the priciest runs 1.25%. But as with all ETFs, ETNs carry the same transaction costs for the investor as a stock. So, frequent trading can erode gains.

Still, in spite of the question mark over their tax treatment, ETNs are becoming popular ways to get a piece of the energy and commodity action. Plus, they are relatively cheap for issuers to launch and run, compared with ETFs, according to Ptak. That makes for a lot of new products. As of May 31, there were 78 ETNs holding $6.5 billion-with 52 having been launched so far this year, according to Morningstar.

At the moment the majority of the wealth is concentrated in a handful of names, including the iPath series from Barclays, the biggest issuer at the moment, with 17 ETNs holding 54% of U.S.-listed assets.

One of the biggest winners among ETNs is the iPath Dow JonesAIG Commodity Index, the biggest commodity instrument among ETNs and ETFs. It held $3.5 billion as of May 31. The next largest ETN is the iPath MSCI India, which holds $739 million in assets. The assets in the rest of the pack drop off rapidly, with 42 of the 78 ETNs holding less than $10 million.

“A lot of them just came online, and they haven’t had an opportunity to gain traction on the market,” Ptak says.

Elizabeth Wine is an author with On Wall Street magazine. For more information about this article, please visit http://www.onwallstreet.com

Cream of the Crop of ETF Signals Services

Since Exchange Traded Funds (ETFs) are relatively new on the investment scene, there aren’t as many signal services for these products as there are for other asset classes. Run an Internet search for futures signals services and you’ll turn up hundreds of options. Forex is the undeniable king of the signal service world. It would take investors hours, if not a couple of days, to sift through all the of the forex signals services on the market.

Like forex before them, ETFs have surged in a popularity in recent years and this is sure to lead to more pick services hitting the market. We’ve witnessed astronomical growth in the accessibility of forex trading to retail investors and the resulting swell in signal services. By all accounts, ETFs are blazing a similar trail, so we thought it would be a good idea to talk about some of the things you’ll want to look for when considering an ETF signal service.

Is the Service for Active or Passive Investors?

One point about ETFs that is brought up all the time is that they trade just like stocks. To be sure, that is an advantage, but it can make shopping for an ETF signal service a bit confusing. Due to the fact that ETFs do trade like regular shares of stock, many ETF pick services are geared toward active investors or even day traders. They may recommend several ETFs to trade per day, but what do you do if you’re not an active trader?

Obviously, you need to do your homework and find one that best fits your investing style. We’ve come across some pretty good options for investors with broader time horizons when it comes to ETF pick services. Some may recommend one or two trades a week. We’ve even found a few that feature an ETF of the month. These are more suitable options for investors that don’t want to be tied to their computers all day.

Along these same lines, we should briefly discuss leveraged ETFs. You may have heard of these products. They are designed to give two times, or in some cases triple, the daily performance of the group of stocks or index the ETF tracks. Leveraged ETFs are risky bets and not for every investing style, so if you come across a service that specializes in this area of the ETF world, be sure they can show you some historical data regarding their performance before committing money to the service.

Is the Signal Service Versatile?

Another great thing about investing in ETFs is that they touch every corner of the financial market. Stocks, commodities, bonds, currencies. You name it and there’s probably a corresponding ETF and probably a bearish ETF to go along with it. And with new ETFs popping up seemingly every week, the choices just get broader and broader.

As this applies to signal services, you’ll probably want to find one that gives you exposure to more than one type of ETF. For example, there are dozens of ETFs that track energy stocks. Since the energy sector is so large, encompassing oil, natural gas, coal, solar and other subsectors, an ETF pick service could, in theory, recommend a new energy ETF for a few months.

That’s not the type of signal service you want to be involved with. After all, part of the reason we invest in ETFs is for diversification. When shopping around, ask the developer to provided you with a list of recent recommendations to get a sense for how diversified the picks are.

Read the Fine Print

This is a point we don’t often talk about when it comes to signal services, but it’s worth noting. Read the fine print regarding the service you’re considering. This is where the developer is going to tell you that they’re not responsible for any trading losses you may incur while using their system and that past performance is no indicator of future results. Yes, reading this legal mumbo jumbo can be tedious, but it will keep you from getting unrealistic expectations and being surprised, in a bad way, in the end.

Ultimately, we’re fans of ETF signal services that don’t just feed investors trade picks, but those that also teach you a little something as well. While ETFs are all the rage in the investing community, there are still scores of investors that don’t know the first thing about ETFs and how to properly integrate them into their portfolios. Consider this the “teach a man to fish” principle. It’s great to have a service that feeds you winners, but it’s even better to have one that empowers to you find winners on your own. Most signal services have a specific pattern or setup that they look for when picking trades and if you watch closely enough, you’ll be able to discern the patterns on your own and become an astute ETF investor.

Maximize Your Portfolio with ETFs

Many people enjoy trading ETFs as they present a simple and diversified method of trading an index or commodity. Although investors may have a preference for certain ETFs, most investors do not have a system in place for trading ETFs. In this article we’ll look at what specifically an ETF is, the benefits of ETFs, and a way of trading ETFs that can be both lucrative yet safe at the same time.

To begin with the basics, ETF stands for Exchange Traded Fund. As the name suggests, it is a fund that is traded, like a stock, on a stock exchange. The fund tracks an index, commodity, or a basket of assets. For example, there are funds that track various exchanges (such as SPY which tracks the S&P 500 and is comprised of over 500 selected stocks over 24 industry groups); there are funds that track a commodity (such as SLV which roughly tracks the price of silver); and there are funds that track other assets such as bonds, real estate (REITs), currency, etc. ETFs cover everything from broad-based indexes to international and country-specific indexes to industry sector-specific indexes.

The benefits to ETF trading are numerous. They include:

  • Diversification over a number of assets and the relative stability of an index fund.
  • Ability to buy as much or as little as you want, just as you would a stock.
  • Ability to buy long or short, and with hedging strategies, just as you could with a stock.
  • Expense ratios of ETFs are usually lower than most mutual funds due to lower marketing and distribution expenses and the fact that ETFs are usually not actively managed.
  • Ease of investing in commodities which otherwise would be difficult to acquire (oil for example – very messy to own physically; or silver as another example – a $50,000 purchase of the physical metal is extremely heavy to carry home!)
  • Transparency in terms of both the portfolio as well as pricing which is updated constantly throughout the day.

With this background, let’s look at one possible strategy of maximizing an investment portfolio through the addition of ETFs.

First, always consider risk management. We would suggest investing roughly 10% of your overall portfolio into ETFs, with each ETF representing only 1% of your overall.

Next, focus on the “Hot Hands” concept. Basically you are buying the top performing funds of the recent past and holding onto them for the upcoming period. We suggest using a period of one month. ETFs that perform well during one month can be expected to continue doing well the next. Start off by purchasing the top 10 performing funds of the last month. Of course not all will do well, and each month you will remove those that drop from the top 10 list and add the new ones that enter the list. By following this technique, you will always have the best performing ETFs in your portfolio! All you require is a listing of the top performing ETFs and you simply select the top 10 – the work is already done for you!

A final thought on maximizing the profits in your ETF portfolio is to take advantage of seasonality trends. Not all stocks (and therefore ETFs) act the same in bearish and bullish seasons. Although summer is considered ‘bearish’, the Dow Utility stocks tend to act bullish during this time. At the beginning of April, you may want to start looking at “IDU” (an iShares ETF that mimics the Dow Utilities). IDU is generally bearish from May to September.

By playing an ETF such as IDU, you are trading the whole index, not an individual stock, and this is important. When we are looking at deep seasonal undercurrent patterns, the effects of these are more visible in the whole market itself rather than any one individual stock.

As winter rolls around, IDU tends to turn bearish, and our focus is better drawn to the Dow Industrials, which are usually bullish from October to April. Again, we want to look at trading the whole index here, and a great way to do this is through the “DIA” iShares ETF which mimics the Dow Industrials.

In summary, ETFs are a great way to play a market sector and have many advantages over both regular stocks as well as mutual funds. By utilizing some of the strategies we’ve discussed here you now have an advantage over other traders, benefiting both your portfolio as well as your pocketbook!

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