Common ETF Investing Techniques
The unique structure of exchange-traded funds makes sophisticated investment techniques possible.
Diversification
ETFs are effective diversification tools for managing risk. For example, investors can guard against over-concentrated equity positions by using ETFs as single stock substitutes. This hedging technique can reduce risk and volatility by letting stockholders diversify away from large equity positions in the companies they own or at which they work. Investors should be cautious, though, as some ETFs may be concentrated heavily in just a few stocks or a volatile industry and may not provide the level of diversification expected.
Leverage
Like individual stocks, ETFs can be leveraged with margin. Margin is borrowing money from a broker to buy securities and involves considerable risk. Minimum maintenance requirements are enforced by FINRA (Financial Industry Regulatory Authority) and by individual brokerage firms. While margin investing can be profitable for investors who are correct about the direction of their holdings, the interest charges or borrowing costs can deteriorate returns even beyond the amount deposited.
Options
ETF investors have a multiplicity of option strategies at their disposal. Purchasing call or put options is an aggressive technique. An options investor can control a large number of ETF shares by paying a premium for an option on the ETF. The premium price is a fraction of what it would cost to purchase the shares in the open market. This provides an options investor with a great deal of leverage and a high risk/reward opportunity.
A more defensive approach uses put options in conjunction with portfolio holdings. Buying protective puts on ETF positions would insure a portfolio against declining prices. There are many other tactical possibilities with options.
Shorting
ETFs, like individual stocks, can be shorted. Shorting involves selling borrowed shares an investor does not own in expectation of the price of an ETF declining in value. If the ETF does decrease in value, it can be bought by the short seller at a lower price, which results in a profit. Shorting is an advanced technique and involves substantial risk.
Investors should consider the investment objectives, risks, charges, and expenses of an Exchange Traded Fund (ETF) carefully before investing. A prospectus contains this and other information about the ETF and can be obtained from the issuer. The prospectus should be read carefully before investing.
Options involve risk and are not suitable for all investors. Detailed information on our policies and the risks associated with options can be found in Scottrade's Options Application and Agreement, Brokerage Account Agreement, and Characteristics and Risks of Standardized Options (available at your local Scottrade branch office or from the Options Clearing Corporation at 1-888-OPTIONS or by visiting www.888options.com). All option accounts require prior approval by Scottrade. Market volatility, volume, and system availability may impact account access and trade execution. Supporting documentation for any claims will be supplied upon request.
Margin trading involves interest charges and risks, including the potential to lose more than deposited or the need to deposit additional collateral in a falling market. Scottrade's margin agreement, available at scottrade.com or through a Scottrade branch office, contains the Margin Disclosure Statement and information on our lending policies, interest charges and the risks associated with margin accounts.
Diversification does not assure a profit, or protect against loss, in a down market.