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The Basics of ETF Trading

The Basics of ETF Trading
April 26
02:11 2012

The ETF is an excellent investing tool that can give you access to a wide range of sectors, markets, commodities, currencies, and even leveraged and inverse options through a trading process that is almost indistinguishable from buying a stock.

However, the fact remains that an ETF is not a stock—the many close resemblances notwithstanding—and there are issues you need to understand if you are going to make ETFs a part of your trading strategy.

First, remember that like a mutual fund, an ETF is made up of a “basket” of underlying securities. While the ETF managers do their best to match the value of the fund’s benchmark as closely as possible, it is simply not possible to do so perfectly. This results in what is known as “tracking error,” and it reflects the difference between the performance of the ETF and the performance of the benchmark—usually to the slight detriment of the ETF.

This fact leads us to a couple of pieces of advice. One is to avoid trading ETFs during highly volatile market sessions. High volatility tends to increase the tracking error, simply because the underlying assets are changing price a little faster than the ETF can keep up. As a result, the bid/ask spread for the ETF will tend to widen, and that makes trading more expensive.

Another is to avoid placing ETF orders shortly after the market open and shortly before the close. This is partly the result of the fact that the ETF may be responding to substantial movements taking place in some of the underlying assets—particularly after the session opens—and partly because as the session draws to a close, market makers begin tidying up their accounts, and bid/ask spreads tend to widen. Staying away from the first and last 30 minutes of the session will generally avoid most of these issues.

When it comes to ETFs that include assets that trade on other markets—such as international stocks—you also need to account for these same conditions in those markets. You might not make a habit of checking on volatility in the British or German markets, but if you’re preparing to trade an ETF that includes stocks traded there, you should. Also, the same rules about trading near the session open and close apply to international markets, so watch your time zones when you trade ETFs with international components. (Fortunately, Asian markets—which include Australia—do not trade during U.S. market hours.)

It’s not just a question of international securities, either. Even within the U.S., certain commodity contracts trade within a narrow timeframe. Grain contracts trade on the Chicago Board of Trade (CBOT) from 10:30 a.m. until 2:15 p.m. Eastern time (yes, these are odd times, but we don’t make the rules), for example, and metals contracts trade on the Comex Metals Exchange from 8:20 a.m. until 1:30 p.m. Eastern. You’ll want to trade ETFs with such commodity components during the midst of the appropriate market sessions.

Another way to avoid large bid/ask spreads is to select ETFs that have a healthy trading volume. With so many ETFs available, not every one of them is the darling of investors, and low volume can delay fills of limit orders and just plain make your trades more costly. Expense ratio is still the top consideration when comparing two similar ETFs (that is, funds that achieve the same investment objective for you), but all else being equal, go for the one with consistently higher volume.

Finally, since your trading account is almost certainly not tax-advantaged, watch out for the distribution dates of the ETFs you hold. There have been cases in which certain ETFs—particularly leveraged ones, and inverse funds during the 2008-09 meltdown—generated fantastic short-term capital gains that translated into hefty tax bills for investors. While fund managers do generally try to monitor capital gains, if many ETF holders force redemptions, the managers will have no choice but to sell and incur those gains.

So if taxes are a significant concern for you, watch your trading dates when distribution season comes around. For most ETFs this is in the fourth quarter, and you can research it easily enough for any fund that interests you. If you are holding an ETF that incurs a large capital gain, you might want to get out before the distribution date. Similarly, it might make tax sense for you to avoid buying in until after the distribution date passes.

ETFs can be a potent weapon in your trading arsenal, but make sure you fully understand the most efficient ways to use them before you add them to your portfolio.

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