ETFs, also known as Exchange Traded Funds, are essentially mutual funds that are traded on a stock exchange like regular stocks of a company. However, unlike mutual funds that can only be bought and sold at the end of a trading session, ETFs can be bought and sold at any point throughout a trading session, just like stocks.
Since an ETF combines the diversification benefits of mutual funds along with the liquidity of stocks, it is widely regarded by many investors as one of the best beginner-friendly investment options in the market. That said, there are several ETF trading strategies that many traders and investors use to profit off the liquidity and short-term price movements offered by the funds.
If you’re on the lookout for some ETF investing strategies to employ, here are some that can help you out.
Systematic Investment Plan (SIP)
Starting a Systematic Investment Plan (SIP) is one of the easiest ETF investing strategies. An SIP strategy requires you to invest a fixed amount of money at the same time each month in an ETF of your choice, irrespective of the price that the ETF is trading for. When done for a long enough period of time, you can benefit from the rupee cost averaging phenomenon, which can end up bringing your overall cost of investment down.
Through the SIP route, you get to purchase more units when the price of the ETF is low and fewer units when the price of the ETF is high. When you carry this ETF strategy out for a reasonably long period of time, the overall cost of your holdings will automatically be averaged out. All in all, rupee cost averaging is a powerful phenomenon that can help you earn significantly higher gains.
This is one of the most popular ETF trading strategies that short-term traders typically use. Swing trading basically entails trying to capture short-term price movements of an ETF. The trades under this ETF strategy are typically kept short and last only for a few days to weeks. The high liquidity that ETFs enjoy combined with the freedom to buy and sell ETF units throughout the day makes them the perfect instrument for executing such an ETF strategy.
Here’s an example of how swing trading can work for an ETF. Assume that there’s a Nifty 50 ETF that’s trading for around Rs. 80 today. You have a bullish view on the market and so, you buy 100 units of the ETF for Rs. 80 each. After around 4 to 5 trading sessions, the ETF’s price per unit goes all the way up to Rs. 90. You sell all the 100 units of the ETF at Rs. 90 each and walk away with a profit of Rs. 10 per unit, which comes up to Rs. 1,000.
Sector rotation ETF investing strategy involves picking the sectors that are currently in demand and doing well. This ETF trading strategy is quite simple and easy to execute, making it an ideal option for beginners. For instance, in view of the current COVID-19 situation, pharmaceutical stocks are having a really good run in the market.
A trader wanting to use the sector rotation strategy would have to invest in pharma sector ETFs. And once the pharmaceutical sector goes out of favour, the investor would book profits and rotate the sector by moving on to more defensive sectors like the FMCG sector ETFs.
On a similar note, ETFs can also be used to profit off seasonal trends. For instance, the travel and tourism industry is highly seasonal. An investor looking to use a seasonal rotation ETF strategy may choose to stay invested in an industry only for a certain period of time. Once the season blows over, the investor would cash out of that industry and invest their capital in other trending seasonal industries.
Another hugely popular ETF trading strategy is short-selling. Short-selling entails selling an ETF for a higher price and then buying the same ETF back for a lower price. The difference between the selling price and the buying price would be the profit that you get to enjoy. That said, short-selling is one of the more riskier ETF trading strategies around, and should always be executed with the utmost caution.
Shorting an ETF is a great way to experience some returns in a market that’s on a downtrend. Here’s an example of short-selling. Assume that there’s a Nifty Bank ETF that’s trading for around Rs. 50. You have a negative outlook and expect the ETF to decline. And so, you short-sell around 100 units of the Nifty Bank ETF at Rs. 50 per unit today. If the market moves in your favour, as expected, and the price of the Nifty Bank ETF declines to around Rs. 30 per unit, you can then buy back 100 units of the Nifty Bank ETF at Rs. 30 per unit to close out your position. The profit that you get to enjoy on this trade comes up to around Rs. 2,000 (Rs. 20 x 100 units).
Many traders and investors widely use ETFs to hedge their investment risk. Since ETFs tend to closely track a sector, an industry, or an index, they act as great instruments for hedging risk. For instance, let’s assume that you have an open call position on an index like the Nifty 50. You can use a corresponding index ETF like the Nifty 50 ETF to protect your option position from downside risk. Such a hedging strategy would require you to short-sell the Nifty 50 ETF. This way, you can protect your index option position from going into losses.
Alternatively, if you have invested in a Nifty 50 ETF and wish to protect your investment from downside risk, you can also execute a reverse of the above-mentioned strategy. This would require you to either short-sell the Nifty 50 futures contract or buy put options of the Nifty 50 index. By doing so, you can effectively prevent your investment in the Nifty 50 ETF from going into losses.
As you can see from the above ETF trading strategies, Exchange Traded Funds are some of the most versatile investment instruments available for both beginners and seasoned investors alike. If you’re interested in investing in ETFs, you’ll find the strategies detailed above useful.