Despite the “mechanical” issues all exchange-traded funds face, they are better than sliced bread that you can butter on both sides.
The ability to trade benchmark indexes – like the S&P 500, the Dow Jones Industrials Average, the Nasdaq Composite, all kinds of sub-indexes, and every asset class imaginable with minute-by-minute price discovery and liquidity – was made possible by ETFs. They’re one of Wall Street’s greatest products.
But, even though I love (and trade) ETFs, I recommend you take your time getting your feet wet with them. You must beware of the swamp you’re stepping into.
If you play the stock market, ETFs, and funds the right way, you’ll be okay. Just exercise a lot of caution, and follow this smart, profitable way to trade ETFs.
Follow the Money
There are so many pathways investors take to make money in the stock market. Too many to mention, and too many to waste your time trying.
I make money the easy way, by following a simple path. I follow the path money’s already traveling, either up or down.
Yeah, it’s that easy. If you like labels, you can break it down to “momentum trading” or “momentum investing.”
If money, which I refer to as capital waves, is flowing into a stock, a group of stocks, a market sector, or the market itself, it’s easy to see that path it follows.
Those stocks and markets will be going up. And more than likely, they’ll be going up as “volume” – which is the number of their shares being traded – rises, too.
The reasons are usually self-evident. There are financial news stories about stocks and sectors moving higher, with tons of insights, analysis, and opinions. If you agree and think that the money flowing into rising stocks is smart money, just follow it.
The easiest and best example of taking a path that’s been cleared for you by others – and profiting handsomely by riding the momentum those stocks possess – is the so-called FAANG stocks.
Each letter in FAANG represents a tech leadership company –Facebook Inc. (NasdaqGS:FB), Amazon.com Inc. (NasdaqGS:AMZN), Apple Inc. (NasdaqGS:AAPL), Netflix Inc. (NasdaqGS:NFLX), and the G is Google, or Alphabet Inc. (NasdaqGS:GOOGL).
If you’d followed the money into any one of those stocks (or, better yet, all of them), you’d still be enjoying a momentum ride that’s made everyone who has done just that very well off, if not filthy rich.
Now, here’s where ETFs come in.
How to Build a More Diversified Portfolio
It takes a lot to buy shares of all those FAANG companies, especially now that they’ve gone through the roof.
Instead, you could have followed them, traded them, and enjoyed their ride higher by investing in any number of ETFs where these stocks are heavily weighted – meaning they are well represented in the portfolio the ETF sponsor puts together. In lots of cases, the exact same portfolio makes up an index.
FAANG stocks are all in the big indexes. So, you could have bought an ETF that tracks the Nasdaq Composite, the PowerShares QQQ Trust Series 1 (NasdaqGM:QQQ); or that tracks the Dow, the SPDR Dow Jones Industrial Average ETF Trust (NYSEArca:DIA); or that tracks the S&P 500, the SPDR S&P 500 ETF Trust (NYSEArca:SPY). All of those ETFs would have given you exposure to the money flowing into the FAANG stocks, and a more diversified portfolio to boot.
You didn’t even need to know that the market was going to go up to profit. All you had to do was trust that the hot stocks would generate their own momentum, enough to take the entire market, based on the indexes we all follow higher.
Or, you could have looked for an ETF that’s less broad-based and has a heavy weighting of the FAANG stocks. There are so many ETFs, you’ll likely find one tailored to your own understanding of which sub-index, sector, or asset class or commodity is attracting capital waves.
For the FAANG stocks, that ETF would be First Trust Dow Jones Internet Index Fund (NYSEArca:FDN). The FAANG stocks account for about 30% of FDN’s portfolio. So, it’s probably the best ETF to closely track the hot money flowing into those hot stocks.
That’s how easy it is to use ETFs to ride along with the smart money driving hot stocks higher.
The Dark Days of Selling
The only problem is that stocks don’t go up forever – that’s pretty obvious. Eventually there will come a time – maybe times, plural – when the market sells off. That’s not a big deal, because that’s what markets do.
What’s a problem in the ETF universe is if the market experiences a big enough selloff, a serious panic could occur. Panic ignites panic selling, whether there’s a good reason to be afraid, or no good reason at all. That’s a huge issue.
In that scenario, the mechanics of how ETFs are constructed, deconstructed, and traded by the “authorized participants,” and what’s at the bottom of the ETF swamp matter – a lot. (I wrote about that in Tuesday’s issue. You can check that out here.)
What to look for, to know if ETF mechanics are about to come undone and crash markets as opposed to a regular selloff, is, first of all, if ETFs stop trading – even intermittently.
If that happens at the open and continues throughout early trading hours while the market’s falling hard, that’s your warning that this selloff, especially if you sense panic, is going to get ugly.
Because I know it’s easier to make more money faster when markets fall, because they always fall harder and faster than when they go up, I’d look to start shorting ETFs, like FDN, QQQ, SPY, and DIA. Or, you can buy puts on them to profit from what I described in Tuesday’s issue as a negative feedback loop, courtesy of authorized participants shorting stocks ahead of ETF holders selling their ETF shares.
There have been some flash crashes, including mini selloffs and panics where ETFs couldn’t be priced, that were caught before they cascaded into some very dark days of selling.
But, by the nature of the mechanics of ETFs and the fact that there are trillions of dollars sunk into them, it’s going to happen one day.
And when that day comes, I have an alternative route you can travel that goes over the hills and far away from the murky waters of this ETF swamp.
This route, this strategy, doesn’t target a fund, or an ETF, or even a stock.
It still enables you to profit from the markets movements, just without the stress or game playing that comes with it. It enables you to potentially collect thousands of dollars automatically each week – and with the ability to predict the movement of the markets with 93% accuracy, this strategy is unlike any other.
A market selloff is coming. Will you be prepared?