An ETF, or exchange traded fund, is a financial product that tracks indexes, commodities, or a large basket of stocks.
It can track overall markets, like the SPY, which tracks the SP 500 (SPX), or IWM, which tracks the Russell 2000 (RUT). ETFs can also track countries, like the FXI tracks China equities, and the INDA matches India. The ETF can also track entire sectors, like XLF tracks the financial sector, and XRT tracks retail.
Basically, ETFs are a neat way to get into different categories of the market without taking on a huge amount of risk. Because they are made up of many individual components, the overall riskiness is mitigated. When you buy a single stock, a lot of times you’re paying a premium for the risk it offers. It’s prone to fluctuations, exposed to both market risk and single-stock risk. The ETF, on the other hand, really only experiences market risk, or systematic risk (the risk we really can’t get rid of). The ETF is diversification in a single asset, exposed to multiple stocks and sectors, which smooths out the overall risk. (Risk is such a fun word!)
ETFs also have lower implied volatility than their larger components, due to the lower perceived risk. (Risk, risk, risk!) Unfortunately, this translates into a lower premium received, due to the risk-reward tradeoff. Investing in a riskier asset often offers higher potential returns, because they have to entice investors to purchase the underlying. A lower risk asset offers lower returns, because you can never have the best of both! Most investors are risk-averse, so they don’t need much motivation to invest in low-risk assets.
Also, ETFs are much less capital intensive than their index option counterparts. For example, SPX (the index) is currently trading at $2,280.37. SPY (The ETF) is trading at $227.67. The relationship between SPY and SPX is seen pretty clearly here- SPX represents about 10 times the value of one SPY option. So if you bought one at the money SPX call right now, that would give you the option to buy $228,370 worth of underlying. One SPY option would give you the right to buy $22,767 worth of ETF shares.
That’s a pretty big difference.
There’s also the realm of leveraged ETFs, which I have no experience in trading. A lot of investors tend to tiptoe around this area, as it’s quite intimidating. Leveraged ETFs are similar to ETFs, given that they track the same products, but use a different “amplification multiplier”. As we’ve already established, the SPX tracks the SP 500 index. SPXL is a leveraged ETF that trades 3x more bullish than SPX, which basically means that a 1% move in SPX translates into a 3% move in SPXL. That’s a pretty volatile security, which is why most traders tend to tread gingerly in this area.
Overall, ETFs provide a great opportunity for smaller portfolio people (like myself) to trade some pretty big things. One of my absolute favorite underylings to trade is the SPY, because of the undercut in total risk. (And because I like to make bets on the market as a whole!) ETFs are the best way to get into all sorts of different areas, and really diversify your portfolio. After all, diversification (and risk mitigation) is the key to success!
Disclaimer: These views are not investment advice, and should not be interpreted as such. These views are my own, and do not represent my employer. Trading has risk. Big risk. Make sure that you can balance your risk/reward, and trade small, and trade often.