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Traders: Which Markets Should You Trade?
As technology increases and trading innovation continues, the world is seeing an expansion in the types of trading instruments that can be used. Even seemingly separate markets are attempting to steal each other’s market share. For example, a person no longer needs to buy gold physically or even from a futures contract, they can simply buy an exchange traded fund (ETF) to participate in the movement of gold prices. Considering that similar scenarios are possible with currencies, commodities, stocks and other investments, traders can fine tune how they trade and tailor it more to their individual circumstances.
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Markets, Markets, Markets
Depending on education and experience, a person may not even be totally aware of the investments or trading vehicles that are accessible with a click of the mouse. Even while avoiding abstract and illiquid markets, traders can find trades within many different markets:
Stock Market: This well known market simply involves buying/shorting shares of a company.
ETF Market: Funds representing all sorts of sectors, industries, currencies and commodities. Trading similar to stocks, these funds can be bought and sold rapidly or held long term.
Forex Market: The largest market in the world. The forex market facilitates the exchange of one currency for another currency. Currencies are always traded in pairs, with many potential combinations available, but only some of which are very liquid.
Options Market: A market which allows participants to undertake positions in the derivative of an asset. Therefore, the option is not ownership of an underlying asset (though rights and obligations exist), but the option price (along with other inputs) fluctuates with the value (or lack of) that the underlying asset is providing.
Contract for Difference (CFD): A hybrid of the stock, forex and options market that allows participants to place trades in a derivative product based on an underlying asset. Generally the CFD does not have an expiry date, premium or commission (see broker’s terms and conditions), but does require the participant generally pay a larger bid/ask spread than what would be seen in the actual physical market for a product. (To learn more about CFDs, see Instead of Stocks, Trade A CFD.)
While there are other markets, these markets are all now easily accessible from home to just about anyone with an internet connection. Each market offers different advantages and disadvantages. Because of this many traders may decide to trade only one market because they feel it suits one aspect of their life or they lack knowledge of available markets. This could mean that traders are not taking advantage of the correct market given their trading style.
Which Markets to Trade?
The style of trading employed, financial resources, location and what time of day a person trades (or wants to trade), can all play a role in which markets will be best suited to the individual. Since some of these markets may not be familiar we will look at two common trader groups and how they could implement the use of other markets to improve their trading. It is important to be aware of such alternatives, as they may provide for some fine tuning which can result in better results over the long run.
Alternative Markets For Day Traders
Since 2000 there has been a steady increase in the amount of turnover in the foreign exchange markets. This has meant an increase in the number of day traders opening accounts with forex and CFD brokers, which have also increased in number. The main lure is that minimal investment is required. Accounts can often be opened for as little as $100-$1000 and will allow individuals to day trade global currencies, indexes and commodities. With the forex market the trader is actually exchanging one currency for another, possibly in an account denominated in yet another currency. It seems nice – low barriers to entry, generally no commission (but a spread is paid), high leverage (high risk/high reward) and free trading tools such as charts and research. But there are alternatives if one wants to trade forex or CFDs, which can encompass just about every other market. (Check out Day Trading Strategies for beginners to learn about some common strategies.)
Exchange traded funds now allow traders to partake in the currency moves by making trades on the stock exchange. While opening a day trading stock/ETF account will require more capital, there are advantages in that ETFs themselves can be leveraged or unleveraged. This means someone who wants to take on additional risk/reward for each incremental price movement can do so by buying a “3X bull” ETF for example. Also, with an ETF, a trader is not required to pay the spread. Instead, they can sit on the bid or offer providing liquidity and thus collecting ECN rebates (offsetting commissions, or providing additional profit). This is very advantageous in currency pairs with limited movement, or when the trader wishes to implement a scalping strategy.
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ETFs also allow a trader to partake in other markets such as the movement of oil gold, silver or stock indexes; traders can move out of the CFD market and begin trading ETFs as well, providing them with a greater range of products. Depending on trading style, using ETFs, CFDs and the forex market may be wise. Different instruments can be used to hedge or take advantage of disconnects in price such as a currency pair moving without the corresponding ETF moving (or vice versa).
Alternative Markets For Long Term Investors
Commodities often attract long term investors, yet they may be unfamiliar with futures markets and so they have not participated directly in the movements of commodities such as gold, silver or platinum. Also, it is unlikely they have different currency exposure. And while they may have considered options trading, the time-framed nature of the instrument does not appeal to their trading plan.
Here is another opportunity where understanding different markets can open new doors even for conservative investors who make few trades. After learning about the different markets, the forex market can be used to gain currency exposure. ETFs can also be used to gain currency exposure, as well as participate in the price movements of gold, oil, silver or even other global economies. CFDs can be used by long term traders since the bid/ask spread is minimal over the time frame and they provide some of the benefits of options, but without the expiry date. For instance, large blue chip stocks are often available via CFDs. The stock is not actually owned, which allows for the participation in price movements with less capital in use (because high leverage can be used if desired), but the CFD does not provide voting rights or any of the perks associated with ownership of a piece of that company. When trading any instrument it is important to be aware of taxes and how the instruments fit into overall objectives, including retirement. Each instrument may be treated slightly different; therefore it is wise to seek out the advice of a professional.
It is important to be aware that alternatives are out there. This does not mean every alternative will be good for every individual, but using a combination of markets or fine tuning how we interact with those markets can have an impact on results. For some individuals this may mean they need to switch markets as their success is unlikely if they continue to do what they are doing. On the other hand, incorporating other markets may provide benefits like small changes in costs, capital outlays and risks that can have large effects over the long run. Becoming familiar with all the markets available will allow for more opportunities and potentially increased profits or reduced costs. (For related reading, take a look at 5 Equity Derivatives And How They Work.)
What are safe-haven assets and how do you trade them?
Safe-haven assets are used by investors to limit their exposure during times of market instability. If traders identify which assets are likely to appreciate while others decline, they can prepare themselves for market movements.
What are safe-haven assets?
A safe-haven asset is a financial instrument that is expected to retain, or even gain value during periods of economic downturn. These assets are uncorrelated or negatively correlated with the economy as a whole, which means that they could appreciate in the event of a market crash.
There are certain characteristics that assets often have that contribute to their reputation as a safe-haven, which include:
- Liquidity: the asset needs to be easily convertible to cash, at any time
- Functionality: the asset needs to have a use that will continually provide long-term demand
- Limited supply: the growth of supply should never outweigh the demand
- Certainty of demand: the asset is unlikely to be replaced or become outdated
- Permanence: the asset should not decay or rot over time
Not every safe-haven will have all of these characteristics, so investors have to make a judgement about the most suitable safe haven for the economic climate. It is important to remember that what makes a good safe-haven for one market downturn may not show the same results in another, so investors have to be clear about what they are looking to gain from using safe-haven investments.
How to trade safe-haven assets
Market downturns are an inevitable part of market cycles, which means that it is in an investor’s best interest to prepare themselves for them as much as possible.
In times of financial crisis, assets that are viewed as safe-havens tend to outperform the vast majority of markets. Although safe havens are primarily used by investors to protect the value of their portfolio, it is important for traders to be able to identify safe-haven assets, and use this understanding to anticipate price movements and implement their own strategies.
For example, the move out of ‘riskier’ assets could cause a sudden drop in the market price as investors flock to safe-havens, which means that you might consider getting out of any long positions or going short. But if you’re confident that you can identify the safe-havens of the moment, then there is the potential to profit from rising prices.
There is no definitive way to trade the patterns of safe-haven assets, as it all depends on your motivation. But whether you are looking to take advantage of price movements or adjust their own positions to protect themselves from falling prices, it is crucial to understand the prevailing market sentiment surrounding safe-havens.
Examples of safe-haven assets
Popular safe-havens can change over time, so it is important to keep up with investment trends. However, there are a few safe-havens that have remained favourites over the years, including:
When people think of a safe-haven, they will most likely think of gold. As a physical commodity, the price of gold is not often influenced by the decisions of central banks on interest rates, and unlike paper currencies, its supply cannot be manipulated by actions such as printing.
Perhaps the strongest example of gold as a safe-haven was following the 2008 global financial crisis. The influx of investment caused the price of gold to rise by nearly 24% during 2009 alone, for example, and it continued this upward trajectory into 2020.
Many consider the decision to buy gold a behavioural bias, based on gold’s history of backing currencies and as a store of value. The theory goes that because gold has historically been considered a safe-haven, when there are signs of significant market collapse, investors swarm to the precious metal. Gold as a safe-haven has become a self-fulfilling prophecy.
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Government bonds are essentially a fixed term ‘I owe you’ from a government, which have periodic interest payments – treasury bills and notes are a type of bond. The only difference between them is the amount of time before you will be reimbursed in full. Treasury bills have maturities of a year or less, while treasury bonds can have maturities of ten years or more.
Investors tend to have more confidence in bonds issued by governments of developed economies – the most popular are US treasury bills. Their status as a safe-haven is based on the credit status of the US government, and the high quality of income in US dollars. With such a stable income behind the asset, investors consider government bonds to be a risk-free safe-haven, especially because anything invested will be repaid in full once the bill has matured.
For example, in February 2020, stocks plunged due to rising bond yields and ironically sent investors running to US Treasury bonds as a safe-haven.
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For over 50 years, the US dollar has been one of the most popular safe-havens during economic downturns. It exhibits a number of safe-haven characteristics – most crucially, it is the most liquid currency on the forex market.
This confidence in the US dollar came from the 1944 Bretton Woods agreement, which introduced the fixed currency system and made the dollar the world’s primary reserve currency. Even after this system was abolished, the US dollar retained its position as a safe-haven because it represented the world’s largest economy.
Although many thought the dollar’s status as a safe-haven would be damaged by increased volatility, caused by US President Donald Trump’s controversial politics, it would seem that it is still benefitting from safe-haven flows. For example, although trade tensions caused fluctuations across stock markets and commodities, the US Dollar Index saw an increase of 5.29% between January and August 2020.
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The Japanese yen is thought of as a safe-haven as it often appreciates against the dollar when US stocks and government bonds experience volatility.
Post-World War II, the Japanese economy was restructured, which enabled it to catch up with other global economies. The Bank of Japan (BoJ) became highly respected and the yen was established as a major global currency. Despite continued interventions from the government, the liquidity of the yen has continued to attract investors in times of financial distress.
The yen earned its reputation as a safe-haven due to Japan’s high trade surplus versus its debt. The value of foreign assets held by Japanese investors is far higher than Japanese assets owed by foreign investors – this means that when markets become ‘risk off’, money moves out of other currencies and back into domestic markets, which strengthens the yen.
Another part of the reason that the yen continues to act as a safe-haven during periods of market turbulence, is because everyone believes that it is. In a similar way to gold, it has become a self-fulfilling prophecy.
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A study by the central bank of Germany, Deutsche Bundesbank, found that the Swiss franc often appreciated when the global stock market showed signs of financial stress.
Common reasons that investors favour the Swiss franc as a safe-haven currency include the political neutrality of the Swiss government, the strong Swiss economy and their developed banking sector.
The country’s independence from the EU has also made it a popular haven for capital during negative political and economic circumstances. In fact, during the eurozone crisis, so much money was flowing into the franc that the Swiss central bank introduced a temporary currency peg against the euro to try and weaken their domestic currency.
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Investors looking to manage their risk during economic downturns could also choose to turn to defensive stocks, because they tend to perform better than the wider stock market during recessions.
Defensive stocks describe the shares of companies that are involved in providing goods and services such as utilities, consumer staples, food and beverages, and healthcare. They are considered safe-haven assets because they are likely to remain stable due to the constant demand for their products, even in periods of economic instability.
Defensive stocks should not be confused with ‘defence stocks’, which refer to weapons manufacturers and others in the arms trade.
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This information has been prepared by IG, a trading name of IG Markets Limited. In addition to the disclaimer below, the material on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients. See full non-independent research disclaimer and quarterly summary.
Trading around Brexit
Find out how the UK’s exit from the EU continues to affect traders, and discover:
- How you can profit from Brexit
- The markets you should be watching
- Brexit trading strategies for key assets
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11 ETF Flaws That Investors Shouldn’t Overlook
Exchange-traded funds (ETFs) can be a great investment vehicle for small and large investors alike. These popular funds, which are similar to mutual funds but trade like stocks, have become a popular choice among investors looking to broaden the diversity of their portfolios without increasing the time and effort they have to spend managing and allocating their investments.
However, there are some disadvantages that investors need to be aware of before jumping into the world of ETFs.
- ETFs have become incredibly popular investments for both active and passive investors alike.
- While ETFs do provide low-cost access to a variety of asset classes, industry sectors, and international markets, they do carry some unique risks.
- Understanding the particulars of ETF investing is important so that you are not caught off guard in case something happens.
5 ETF Flaws You Shouldn’t Overlook
One of the biggest advantages of ETFs is that they trade like stocks. An ETF invests in a portfolio of separate companies, typically linked by a common sector or theme. Investors simply buy the ETF in order to reap the benefits of investing in that larger portfolio all at once.
As a result of the stock-like nature of ETFs, investors can buy and sell during market hours, as well as put advanced orders on the purchase such as limits and stops. Conversely, a typical mutual fund purchase is made after the market closes, once the net asset value of the fund is calculated.
Every time you buy or sell a stock, you pay a commission. This is also the case when it comes to buying and selling ETFs. Depending on how often you trade an ETF, trading fees can quickly add up and reduce your investment’s performance. No-load mutual funds, on the other hand, are sold without a commission or sales charge, which makes them advantageous, in this regard, compared to ETFs. It is important to be aware of trading fees when comparing an investment in ETFs to a similar investment in a mutual fund.
If you are deciding between similar ETFs and mutual funds, be aware of the different fee structures of each, including the trading fees. And remember, actively trading ETFs, as with stocks, can severely reduce your investment performance with commissions quickly piling up.
The specifics of ETF trading fees depend largely upon the funds themselves, as well as the fund providers. Most ETFs charge under $10 in fees per order. In many cases, providers like Vanguard and Schwab allow regular customers to buy and sell ETFs without a fee. As ETFs have continued to grow in popularity, there has also been a rise in commission-free funds as well.
It’s also important for investors to be aware of an ETF’s expense ratio. The expense ratio is a measure of what percentage of a fund’s total assets are required to cover various operating expenses each year. While this is not exactly the same as a fee that an investor pays to the fund, it has a similar effect: the higher the expense ratio, the lower the total returns will be for investors. ETFs are known for having very low expense ratios relative to many other investment vehicles. For investors comparing multiple ETFs, this is definitely something to be aware of.
Underlying Fluctuations and Risks
ETFs, like mutual funds, are often lauded for the diversification they offer investors. However, it is important to note that just because an ETF contains more than one underlying position doesn’t mean that it can’t be affected by volatility. The potential for large swings will mainly depend on the scope of the fund. An ETF that tracks a broad market index such as the S&P 500 is likely to be less volatile than an ETF that tracks a specific industry or sector such as an oil services ETF.
Therefore, it is vital to be aware of the fund’s focus and what types of investments it includes. As ETFs have continued to grow increasingly specific along with the solidification and popularization of the industry, this has become even more of a concern.
In the case of international or global ETFs, the fundamentals of the country that the ETF is following are important, as is the creditworthiness of the currency in that country. Economic and social instability will also play a huge role in determining the success of any ETF that invests in a particular country or region. These factors must be kept in mind when making decisions regarding the viability of an ETF.
The rule here is to know what the ETF is tracking and understand the underlying risks associated with it. Don’t be lulled into thinking that because some ETFs offer low volatility that all of these funds are the same.
Lack of Liquidity
The biggest factor in an ETF, stock or anything else that is traded publicly is liquidity. Liquidity means that when you buy something, there is enough trading interest that you will be able to get out of it relatively quickly without moving the price.
If an ETF is thinly traded, there can be problems getting out of the investment, depending on the size of your position in relation to the average trading volume. The biggest sign of an illiquid investment is large spreads between the bid and ask. You need to make sure an ETF is liquid before buying it, and the best way to do this is to study the spreads and the market movements over a week or month.
The rule here is to make sure that the ETF you are interested in does not have large spreads between the bid and ask prices.
Capital Gains Distributions
In some cases, an ETF will distribute capital gains to shareholders. This is not always desirable for ETF holders, as shareholders are responsible for paying the capital gains tax. It is usually better if the fund retains the capital gains and invests them, rather than distributing them and creating a tax liability for the investor. Investors will usually want to re-invest those capital gains distributions and, in order to do this, they will need to go back to their brokers to buy more shares, which creates new fees.
Because different ETFs treat capital gains distributions in various ways, it can be a challenge for investors to stay apprised of the funds they take part in. It’s also crucial for an investor to learn about the way an ETF treats capital gains distributions before investing in that fund.
How to Invest in ETFs
Buying an ETF with a lump sum is simple. Say $10,000 is what you want to invest in a particular ETF. You calculate how many shares you can buy and what the cost of the commission will be and you get a certain number of shares for your money.
However, there is also the tried-and-true small investor’s way of building a position: dollar-cost averaging. With this method, you take the same $10,000 and invest it in monthly increments of, say, $1,000. It’s called dollar-cost averaging because in some months you will buy fewer shares with that $1,000 as a result of the price being higher. In other months, the share prices will be lower and you will be able to buy more shares.
Of course, the big problem with this strategy is that ETFs are traded like stocks; therefore, every time you want to purchase $1,000 worth of that particular ETF, you have to pay your broker a commission to do so. As a result, it can become more costly to build a position in an ETF with monthly investments. For this reason, trading an ETF favors the lump sum approach.
The rule here is to try to invest a lump sum at one time to cut down on brokerage fees.
When it comes to risk considerations, many investors opt for ETFs because they feel that they are less risky than other modes of investment. We’ve already addressed issues of volatility above, but it’s important to recognize that certain classes of ETFs are inherently significantly more risky as investments as compared with others.
Leveraged ETFs are a good example. These ETFs tend to experience value decay as time goes on and due to daily resets. This can happen even as an underlying index is thriving. Many analysts caution investors against buying leveraged ETFs at all. Those investors that do take this approach should watch their investments carefully and be mindful of the risks.
ETFs vs. ETNs
Because they look similar on the page, ETFs and exchange-traded notes (ETNs) are often confused with each other. However, investors should remember that these are very different investment vehicles. ETNs will have a stated strategy: they also track an underlying index of commodities or stocks, and they also have an expense ratio, among other features.
Nonetheless, ETNs tend to have a different set of risks from ETFs. ETNs face the risk of the solvency of an issuing company. If an issuing bank for an ETN declares bankruptcy, investors are often out of luck. It’s a different risk from those associated with ETFs, and it’s something that investors eager to jump on board the ETF trend may not be aware of.
Loss of Taxable Income Control
An investor who buys shares in a pool of different individual stocks has more flexibility than one who buys the same group of stocks in an ETF. One way that this disadvantages the ETF investor is in his or her ability to control tax loss harvesting. If the price of a stock goes down, an investor can sell shares at a loss, thereby reducing total capital gains and taxable income, to a certain extent. Those investors holding the same stock through an ETF don’t have the same luxury; the ETF determines when to adjust its portfolio, and the investor has to buy or sell an entire lot of stocks, rather than individual names.
Price vs. Underlying Value
Like stocks, the price of an ETF can sometimes be different from that ETF’s underlying value. This can lead to situations in which an investor might actually pay a premium above and beyond the cost of the underlying stocks or commodities in an ETF portfolio just to buy that ETF. This is uncommon and is typically corrected over time, but it’s important to recognize as a risk one takes when buying or selling an ETF.
Issues of Control
One of the same reasons why ETFs appeal to many investors can also be seen as a limitation of the industry. Investors typically do not have a say in the individual stocks in an ETF’s underlying index. This means that an investor looking to avoid a particular company or industry for a reason such as moral conflict does not have the same level of control as an investor focused on individual stocks. An ETF investor does not have to take the time to select the individual stocks making up the portfolio; on the other hand, the investor cannot exclude stocks without eliminating his or her investment in the entire ETF.
ETF Performance Expectations
While it’s not a flaw in the same sense as some of the previously mentioned items, investors should go into ETF investing with an accurate idea of what to expect from the performance.
ETFs are most often linked to a benchmarking index, meaning that they are often designed to not outperform that index. Investors looking for this type of outperformance (which also, of course, carries added risks) should perhaps look to other opportunities.
The Bottom Line
Now that you know the risks that come with ETFs, you can make better investment decisions. ETFs have seen spectacular growth in popularity and, in many cases, this popularity is well deserved. But, like all good things, ETFs also have their drawbacks.
Making sound investment decisions requires knowing all of the facts about a particular investment vehicle, and ETFs are no different. Knowing the disadvantages will help steer you away from potential pitfalls and, if all goes well, toward tidy profits.
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