Speculating With Exchange Traded Funds

By Marc Davis AAA

A key axiom of financial advisors urges investors to never put more money at risk than they can afford to lose. But speculators in increasing numbers - as indicated by rising trading volume - have been attracted to fast-moving and often volatile exchange traded funds (ETFs).

SEE: Risk and Diversification: Introduction

In this article, you will be introduced to methods of speculating in these ETFs with three caveats:

1. Speculation assumes a high degree of risk, with the distinct possibility of financial loss.

2. Never speculate with more money than you can afford to lose.

3. Know and understand what you're doing before you do anything in any market.

The article is not a definitive "how-to" guide to speculation, but only an introduction. For those seriously interested in ETF speculation, further study of the intended market is strongly urged.

SEE: The Stop-Loss Order - Make Sure You Use It

A Primer on ETFs
Exchange traded funds are "baskets" of assets with varying values which are bought and sold daily on an exchange at a price which reflects the average price of the underlying assets. The most widely-traded ETFs are the market index funds, which reflect average prices on the S&P 500 and other equity indices. With their diversified portfolios, ETFs can be less risky than a single corporate stock. Because not all the assets in an ETF move in tandem, the losses in one asset may be offset by the profit in another.

In recent times a number of new and innovative ETFs have been introduced which allow trading in foreign currencies (forex), precious metals and emerging markets. ETFs in all categories have enjoyed a surge in popularity, and according to data cited in mid-December 2010, total ETF and ETF product sales amounted to over $1 trillion.

ETFs may be traded through retail brokerage firms with a schedule of competitively-priced commissions paid by the speculator. Major ETFs provide good liquidity, and therefore good price discovery - high trading volume means you can sell your position easily and take your money out with no hassle. High trading volume also mostly eliminates erratic price jumps and drops, thus minimizing downside impact when a large position is sold.

In some cases, market orders, stop loss orders and market-if-touched orders can placed on ETFs. Ask your retail broker if these strategic market orders may be used with the ETF you intend to trade. If you do use these techniques, make sure you understand their functions and how they may also work against you in some circumstances. Here are several strategies for using ETFs to speculate.

Foreign Exchange Speculation (FOREX)
Essentially, this practice comes down to "betting" on one foreign currency against another. Foreign currencies rise, fall or remain stable in relation to other foreign currencies, depending on a variety of immediate, mid- and long-term circumstances, principally in the economic and political realms of the two countries whose currencies are being traded. Other factors, such as natural disasters or good or bad weather, also impact currency prices because of the relationship between the scarcity or abundance of commodities and economic conditions. For trading success, a currency speculator - in fact, all speculators - should be well informed on the markets being traded, and should retain a dispassionate, unemotional approach to trading.

For example, whenever a tradable disparity occurs between one currency and another, the speculator should be prepared to capitalize on the gap. Waiting for the gap to widen to increase profitability frequently leads to a lost opportunity. Other individual and institutional traders also see that foreign exchange gap and their trades tend to close the gap, thus eliminating the margin of profitability.

SEE: The Forex Three-Session System

Precious Metals Speculation
The big run-up in gold prices has prompted more speculators to put money in gold and other precious metal ETFs. Major ETFs are available in gold, silver, palladium and other precious metals which are traded as commodities rather than equities. Also available for the precious metal speculator are baskets of gold mining stocks, which provide another means of speculating in both the production and value of the underlying precious metal.

The same advice for forex trading also applies to precious metal speculation. A prudent, unemotional approach usually proves to be the most successful. Avoid both panic selling and manic buying in the face of a situation bound to drive precious metal prices up. The smartest speculators monitor world economic and political news on a continuing basis because these two factors move the precious metals market up or down.

One final observation from smart speculators to consider: when you've got a profit, take it. Some speculators like to ride an upward trend indefinitely. Sometimes this leads to a precipitous sell-off of the precious metal when the price reaches a chart level that prompts a flock of sell orders. Many speculators cannot get sell orders filled as the markets head limit-down for a period of days.

Emerging Markets
ETFs for emerging markets in Europe, Asia and the Middle East have been generally posting profits over the past several years, although there have been periods of decline during this era as well. ETFs in emerging markets may cover individual countries, regions or entire continents.

As these markets develop and compete for market share in what they produce, the services they provide, and their import-export balance sheets improve, they provide profit opportunities for speculators. Many financial advisors are now urging investors to allocate a small percentage of portfolio assets to emerging markets because of the significant growth potential in this area.

Beyond stocks and commodities as instruments for speculation in emerging markets, bonds - i.e., government and corporate debt - may also be a good vehicle for speculation. As always, thorough knowledge of the vehicle of speculation and external factors which affect its price is necessary for success. SEE:

SEE: An Introduction To Emerging Market Bonds

The Basic Differences
There are two ways to make money in the market: speculating and investing. Some observers say there's not much difference between the two. Both put money at varying degrees of risk. Even with certain guarantees with which principal may not be lost, inflation may erode the purchasing power of the dollar amount invested or put at risk through speculation.

There are two major differences in speculating with ETFs rather than with individual stocks or currencies. These are the permanent baskets of assets of ETFs, and the research factor. ETFs have a generally permanent selection of underlying equities or currencies. These assets, while in the same sector or category, are also diversified, therefore moderating risk. Unless a stock or currency is replaced in an ETF, the basket of assets remains the same. When speculating with individual equities or currencies, as opposed to ETFs, however, the speculator may pick and choose whatever asset is desired rather than buy into a pre-selected portfolio of the many assets represented in a typical ETF.

Researching the price history of any ETF may be easy enough, but researching the individual holdings of any ETF may be more difficult and time consuming. Researching a single stock or currency, or one currency against another, is a much easier proposition.

When researching an individual stock, it's also much easier to do a more comprehensive examination of the senior management team of a firm. Annual reports for the previous year may also be easily available for a look at the company's balance sheet and other aspects of the business that may affect its stock price. But researching all the stocks held in an ETF is a formidable job, and may not be worth the time and effort. What one should keep in mind is that the worst-performing equity in an ETF will depress its market price despite the positive performances of other equities. On the other hand, investing all of your funds in a poor performing stock does not offer the same downside protection that accompanies a diversified ETF investment.

The Bottom Line
For speculation in ETFs in each of the categories above, don't put more money at risk than you can afford to lose. Study the markets in which you intend to speculate, and make it a priority to trade prudently and unemotionally. Above all, when you've got a reasonable profit, take it!

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