How to Use ETFs in Your Portfolio

ETF stands for Exchange Traded Fund. Rather than a traditional mutual fund, these are funds that are on a stock exhange that look, work, and trade like stocks. Some represent a basket of stocks, some mirror an index by trading futures in that index, while some may short stocks or futures. There are several advantages with ETFs over traditional mutual funds:

• They trade instantly, no waiting for the day’s closing price at 4 p.m.
  
• You can buy or sell them with limit orders and have stop loss orders there to protect your investment from a large drop
  
• Many are offered that give you double or triple the underlying index value’s daily change, so you have additional leverage with your money
  
• Many allow you to short either a market index or a stock sector
  
• You can buy them in an IRA or 401k and thus can short stocks that way, benefitting from falling prices with a rising price in the short ETF. You cannot short stocks in a retirement account, because if they move against you (up), you would owe additional funds.
  
• You can use a sector specific ETF to hedge stock positions and have corresponding sell orders in place in all positions
  

Traditional mutual funds don’t allow any of these, you can’t have a preset sell price (stop loss), you can’t buy at a specific price, you don’t get the immediate value when you buy or sell. On top of the mechanics of trading them, traditional funds will usually cost more in fees when you get out than an ETF will, which will trade at the cost of a stock’s trade commission. On Black Monday in 1987, when the market plunged at the open, those who sold mutual funds had to wait until the 4 p.m. prices, which was at the day’s lows, down over 20% on average for that day alone. People, like me, who sold stock at the open had their cash immediately and avoided the day’s plunge.

You can use ETFs for various investment purposes:

• You can use them for investing rather than trying to pick individual stocks
  
• You can buy into or short an entire sector, such as financials, with one trade
  
• You can use them to hedge stock positions, such as using a financial short ETF to protect a long position in financial stocks, or a short index ETF to protect all your long positions at once
  
• You can buy the ‘market’ with an SP500 fund, or short the ‘market’ the same way
  
• You can lessen your risk because there’s no chance of bankruptcy or a bad earnings forecast such as may occur with individual stocks
  
• They allow beginners to safely learn how to trade while remaining diversified without having to analyze individual stocks
  

ETFs have succeeded because of all these advantages. Most now trade millions of shares per day, and I would avoid those that still trade below 100,000 shares daily, which is called liquidity. For beginning investors, these offer the safest way to learn how to trade the stock market with the least risk. Simply buy a long or short S&P500 or Dow 30 fund, put in a stop loss order to protect yourself from a big loss, and you have easily started down the road to safer investing.