What is a ETF?

ETF Stands for Exchange Traded Fund. As someone who has traded for the past two decades, when the market went from relatively few ETFs to literally thousands of ETFs now.

The benefit of an ETF over a mutual fund is that it trades like a stock - you can get in and out of your positions during the day. You may be able to place an order to buy or sell your Mutual Funds during the day, but these trades will not be executed until the close - at the claculated NAV - Net Asset Value of the Mutual Fund.

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Worse case scenario with a Mutual funds is that the market will do something out of the ordinary and you will not be able to get out of your position until the end of the trading day. And if you don't place your order by the end of the previous trading day, your order won't be placed until the end of the next trading day. That's 24-hours of risk time. Whereas with a ETF - you will be able to get out at the open, or 17.5 hours of risk...

Another benefit of ETFs is that you can invest or trade commodities and other investment vehicles that you couldn't trade in the past. This gets a little more complicated, because some commodity ETFs will not make a good investment for the buy and holders out there. They're more for an investment or a hedge type position - like adding gold or oil to your portfolio.

Let's look at some common definitions and discuss them:

What is a ETF? A mutual fund that is traded on a stock exchange.

I don't like this definintion of a ETF because it implies an ETF is a mutual fund, when it isn't. Although there currently is a trend for more mutual finds to become ETFs. The initial benefits of ETF was that there was NO ACTIVE MANAGEMENT - the ETFs were indices - fixed stocks - and this allowed for very low fees. No management also reduces the liklihood of style shift. This is when you invest in a small cap mutual fund and because small caps are underperforming, the manager decides to add a little large cap exposure...

Greed is a powerful motivator.

What is a ETF?  An investment fund, units of which can be bought and sold on a stock exchange. Often used by tracker funds.

This is a much better definition, except for the "investment" part. Who says ETFs are solely for investment purposes. Actually, they're very popular with traders.

What is a ETF?  Collections of stocks that are bought and sold as a package on an exchange, principally the American Stock Exchange, but also the NYSE, CBOE, and Nasdaq.

This is an even better definition - except that comment about the AMEX (american stock exchange). The Nasdaq owns the NYSE.

Why trade ETFs?

  • Reduced risk of substantial loss - stocks can drop 50% because the CEO was caught with his hands in the cookie jar? ETFs are automatically diversified equities, which greatly reduces this risk because there is minimal exposure to any one individual stock. By trading ETFs, you can greatly reduce the risk of a trading catastrophe.
  • Access to more markets - With ETFs, you now have access to markets that were previously difficult and expensive for retail investors to participate in. Government T-bonds, international markets, commodities, and even a currency ETF can all be traded with the same ease and commission cost of an individual stock. With new ETFs being created every month, the realm of trading opportunities keeps growing.
  • Liquidity is never an issue - Unlike individual stocks, in which liquidity can greatly affect how a stock trades, all exchange traded funds are synthetic instruments. As such, the amount of average daily volume that an ETF trades is, for the most part, irrelevant. Even if a particular ETF had no buyers or sellers for several hours, the bid and ask prices would continue to move in correlation with the market value of the ETF that is derived from the prices of the underlying stocks.
  • Lower trading commissions - Prior to the inception of ETFs, if you wanted to buy a basket of stocks within a particular industry sector, you had to pay a separate commission for each stock you wanted to buy. However, through trading in the sector-specific ETFs, you now only pay one commission to buy or sell short an entire group of stocks within an industry. And some mutual fund companies are now allowing no commission ETF trades! They are competing for your money - which means better deals for you.
  • No uptick rule - Unlike individual stocks, ETFs are not subject to the uptick rule that prevents the short sale of stocks on a downtick. This makes selling short an ETF much easier and quicker than with an individual stock.
  • Ability to profit in bear markets - Thanks to inversely correlated "short" ETFs, traders and investors can now aim to profit in bear markets without selling short. If you've always wanted to to take advantage of bear markets, but were not confident with selling short, the "short" or "Inverse" ETFs enable you to take a bearish position with the same simplicity as buying any other ETF. Obviously, the inherit risks of short selling still apply.

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