HOW TO PROFIT FROM TRADING AN ETF AGAINST A BASKET OF ITS COMPONENT STOCKS
With time, trading allows you to anticipate market changes and use them to your advantage.
Its a risky undertaking since there is constant changes in the market
For an investor looking forward to smiling straight to the bank, I would highly recommend picking up that phone, dialling up your stock broker for an ETF. Primarily an ETF is an acronym for exchange traded fund which offers you the investor an attractive, flexible, tax friendly and relatively low cost exchange traded product. A common concern most folks express is liquidity of various investments.
Life as we know it is very unpredictable. Although we try to mitigate unforeseen events, sometimes things just happen that necessitate quick cash solutions. ETFs are very liquid with daily sales and redemption. Profit from trading an ETF against a basket of its component stocks can be enjoyed on daily basis. This is because similar to a stock; ETFs are sold and redeemed daily so you can directly source an ETF through a stock broker or dealer. Moreover EFTs follow a traditional arbitrage pricing system hence, over the years the demand for EFTs has grown both to institutional investors as well as individual investors thus turning them to an investment options in their portfolios of investment.
ETF comprises of a composite of all stocks selected by an investor to form his basket of stocks based on their co-integration. Most ETF are either structured as open ended investment in companies such as shares, bonds but may also consist of ETFS that invest in commodities, futures and currencies.
If you are a short term investor EFTs are ideal for speculation, or hedging a portfolio. Using ETFs you mix and match different securities to achieve short term gains from difficult market conditions, and make a profit the market mismatch on different sectors of the economy. An index ETF allows you to earn exposure to the market of your choice with a single trade.
In fact, you can make a trade on an index of stock and gain exposure to a diversified basket of index components in a fraction of time which is an expense that would need you to acquire individual components of stocks. This explains why ETFs enhance profits from international markets.
To illustrate how an ETF profit on an basket of stocks works, its worth mentioning that the price of ETF is influenced by forces of supply and demand. The imbalances in supply and demand causes the price of ETF to deviate from its underlying value market which is known as intraday indicative value abbreviated as (IIV).ETF has two primary features that promotes its trading portfolio transparency and the ability of authorized participants to redeem them at the end of trading day.
The transparency of an ETF’s holdings enables investors to monitor, and attempt to profit from, discrepancies between the ETF’s share price and its underlying value during the trading day. The market data vendors who are the third party aggregate, calculate an estimate of ETF’s IIV, using the readily available portfolio information an ETF register daily, this information is disseminated on the market trading floor to potential investors to conduct their trading daily.
After the market data vendor trading price has been realised and ETF is trading at a discount to its underlying determined value, you as an investor may buy ETF shares or sell the underlying securities. ETF increased demand as a result of discount will raise its share price and the sales of the underlying securities should lower their share prices hence lowering the gap between the ETF and its underlying value.
Contrary if the ETF is trading at a premium to its underlying market value, you may choose to sell the ETF and/or buy the underlying securities. This action should reduce the ETF share price and/or raise the price of the underlying securities, bringing the price of the ETF and the market value of its underlying securities closer together.
For instance, when an ETF is trading in the market at a discount, authorized participants (brokers) may discover it profitable to buy the ETF shares and sell short the underlying securities. This may imply that at the end of the day, authorized participants return ETF shares to the fund in exchange for the ETF’s redemption basket of securities that they use to cover their short positions. When an ETF is trading at a premium, authorized participants may discover it is profitable to sell short the ETF during the day while simultaneously buying the underlying securities. At the end of the day, the authorized participant will deliver the creation basket of securities to the ETF in exchange for ETF shares that they use to cover their short sales.
An illustration an index of ETF is used to speculate on an upward or downward shift in the market trading, or to hedge against an existing portfolio. This can be illustrated using ETFs.
For example let’s say you have a feeling that the political mayhem in Middle East will make the prices of oil to skyrocket in near future. You also think that this could be harmful to equities of shares in the oil industry, but good for the energy companies in general.
What you could do to hedge against this scenario is to buy shares in X oil company/T&X inverse ETF and at the same time buy shares in Z&Y. This way energy sector index will seek to replicate the performance of X/T&X and capped energy index (comprise of securities from European energy companies).
Suppose your argument is right in case of downturn in the oil industry. You will profit from the uprising in the energy industry by using an ETF as hedge instrument .However, it’s worth to mention that ETF enhances your domestic portfolio in a diversified industrial sectors but are perfect for taking position in international markets.
In conclusion it’s important to mention that ETF gives the investor the opportunity to construct his own basket of stocks to trade against an index (an ETF representing the index composed). In investment common sense is an important tool for any investor whether short or long-term