Even though they’ve been around since the early 1990s, Exchange-Traded Funds (ETFs) only started to gain real traction a decade ago. In the aftermath of the financial crisis, many investors moved into ETFs as a way of minimizing their risk and being able to control their portfolios easily.
Another use of ETFs, by contrast, is following market trends. Index-tracking ETFs can help investors understand the overall market, according to Meir Barack, founder of Tradenet, one of the world’s largest day-trading academies.
“I’m a trader, so I use ETFs like $SPY for S&P500 or $QQQ for Nasdaq as the best indicators for the market directions. I always tell my students that the trend is your friend. So if you are trying to long a tech stock, for example, you must use the Nasdaq ETF as an indicator of where the trend is going. If it’s going red, it’s often better to avoid longing the tech stock,” says Barak, whose Tradenet day trading academy offers a range of day trading courses on technical analysis with funded trading accounts as well as a YouTube Trading Channel (an online trading academy), where he explains some aspects of technical analysis and conducts daily live streams of his trading.
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ETFs represent a basket of stocks that track a market index, a sector, or an industry. Currently, there are more than 2,000 of them, and each investor is guaranteed to find one that’s best suited for them based on their risk profile and the companies they’d like to gain exposure to.
As the stock market embarked on one of the longest bull runs in history, ETFs continued to gain popularity. Investors didn’t need the strict oversight and management of their holdings as provided by hedge funds and mutual funds, but simply needed to have exposure to particular indexes and sectors to generate profits – something that ETFs could provide without charging an arm and a leg. These factors caused investors to flock into ETFs, which have amassed nearly $5 trillion in AUM.
This popularity comes with a cost, though. Because ETFs have so much money concentrated in them, they’ve become a very powerful market force. When the market eventually starts to sell off, ETFs will likely send it into a major crash as they start selling to adjust their positions. However, we’re currently in uncharted waters, and nobody can know for certain how ETFs will react in the event of a sell-off, and what effect they’ll have on the markets and the economy.
Despite the above cautions, ETFs can still be very useful for investors, and even for day traders who don’t hold a position for more than one day. Even though they’re designed for long-term, passive investing, ETFs can be a useful instrument for determining market trends.
There are several ways in which ETFs can help a day trader. For one, they have the properties of stocks: i.e., they are bought and sold throughout the day, so a day trader can generate profits by trading them while exposing themselves to less risk. However, larger ETFs usually don’t move by more than a couple of percentage points, and therefore the profits will usually be very small, particularly in the case of index-tracking ETFs such as SPY.
More volatile ETFs that are invested in industries like biotech offer more opportunities to profit. For example, on May 13th the S&P 500 Index was down 2.5% due to the escalation of the trade war. This presumably would have minimal effect on biotech companies, yet the iShares Nasdaq Biotechnology ETF (NASDAQ:IBB) was down 3.6% creating a buying opportunity for investors. In addition, there are ETFs that track specific commodities such as gold or oil, or even currencies. They’re still traded on a stock exchange, so day traders can use them to reap profits from fluctuations in the underlying commodities or currencies.
One thing to keep in mind when planning to day-trade ETFs is to look at their liquidity. Low-liquidity ETFs will transact much slower and might not be well suited for day traders. It is also important to keep in mind that some ETFs, such as those invested in gold (GLD) or oil (USO), can have much higher transaction costs compared to stocks, which will eat into the profits.
For a day trader to take advantage of ETFs, they need to first look at the overall market by following an index-trading ETF such as SPY or QQQ. Investors looking to profit from small-cap stocks should check out IWM. The next step is to establish which stocks they’d like to focus on during a particular trading session. Look at the sector or industry that these stocks are part of, if the overall sector and industry is going down, then probably the best approach would be to consider shorting that stock – or to avoid going long, taking another stock instead.
To sum up, having an understanding of ETFs can be helpful for day traders, allowing them to more easily grasp the market trends and make decisions. ETFs can also be a great day-trading security, although it’s important to take into account the ETF’s liquidity, volatility, and transaction costs.
Disclosure: None. This article was originally published at Insider Monkey.