ETFs trading explained: How to trade ETFs

What is ETF trading?

ETF trading is the buying and selling of exchange-traded funds to gain exposure to a broad range of assets and speculate on price fluctuations.

Exchange traded funds (ETFs) are among the most popular financial instruments that investors add to their portfolios for exposure and diversification. Rather than having to research and analyse individual stocks, you can track the performance of a group of stocks or an index, as well as trade commodity funds by investing in ETFs.

Are you new to the market and looking to have ETF trading explained? In this guide, we look at ETF trading in more detail, explaining how you can start ETFs trading and looking at other important information you may need to know.

What is an ETF?

The ETF definition refers to a financial security that contains a basket of stocks, commodities or other assets that in some cases track a benchmark to measure their performance. These are typically based around an index, industry or theme. They can track a particular group of shares, bonds, commodities, currencies or other assets.

According to US investment company Blackrock, as of August 2022, there were more than 8,000 ETFs available globally. Investor demand and improvements in technology have made ETFs easy to invest in. Traded on stock exchanges, ETFs can be bought and sold instantly throughout a trading day, allowing investors to react quickly to any upcoming market trend. 

In some ways, ETFs are similar to mutual funds, but mutuals are bought directly from a fund manager and prices settled only once a day.

What is an ETF designed to do? Exchange-traded funds were developed as index investing became increasingly popular in the 1980s and 1990s. The first ETF launched in the US in 1993, as an instrument to track the S&P 500 Index (US500). 

ETF trading provides a way for investors to gain exposure to assets that were not easy to trade previously, such as physical commodities or stocks on international exchanges. For example, commodity ETFs give access to oil, precious metals and agricultural markets. 

The first commodity ETF for gold bullion was launched in 2003 on the Australian Securities Exchange. In 2004, State Street Corporation (STT) launched SPDR Gold Shares (GLD), the first US ETF backed entirely by physical gold – it surpassed $1bn in assets within its first three trading days.

How do ETFs work?

To understand how an ETF works, let’s walk through how one is created. New ETFs must be approved by the financial regulator in the market where they will be listed. For example, in the US, the sponsor files a plan with the Securities and Exchange Commission (SEC). 

Yet, how are ETFs traded? The creation and redemption process allows authorised participants, such as market makers or trading desks at large institutional investors, to place shares of the securities listed in the ETF in trust and create ETF units. 

ETFs trade on the stock market and are available throughout a trading session. Investors can buy the fund units, or shares, in the same way as they can buy shares in a company stock. The process of creating and redeeming shares ensures the ETF price remains in line with its net asset value (NAV).

Shareholders indirectly own the fund’s securities, and typically receive an annual report. Shareholders are entitled to a share of any profits in the form of dividends or interest, and they may get a residual value in the event that the fund is liquidated.

Types of ETFs

There are many different types of ETFs, covering a range of asset classes and investment approaches.

• Equity ETFs

Equity exchange traded funds track indices covering groups of stocks, such as large companies, small businesses, dividend-paying stocks, and companies based in certain countries or specific sectors. For example, technology, consumer, banking and pharmaceutical ETFs allow investors to gain exposure to a variety of stocks in those sectors instead of buying an individual stock that may underperform.

• Index ETFs

Index exchange traded funds allow investors to gain exposure to an entire stock market index, such as the S&P 500 (US500), the US Tech 100 (US Tech 100) or the FTSE 100 (UK100). Index ETFs aim to track the performance of their benchmark index, either by holding the shares of the constituent stocks in the index or other investment products that follow its price movements. 

• Sector ETFs

Sector exchange traded funds track a basket of company stocks in a specific industry. For example, the iShares Nasdaq Biotechnology ETF (IBB) invests in the stocks of biotechnology firms and the Global X Autonomous & Electric Vehicles ETF (DRIV) invests in car manufacturers, semiconductor producers, automotive technology companies and other suppliers in the electric vehicle industry. 

You can use sector ETFs to invest in specific areas of the market or to hedge against other positions in your portfolio. For example, If you have significant exposure to a particular sector, you could mitigate this risk by shorting a sector ETF.

• Bond ETFs

Bond exchange traded funds provide investors with fixed income to diversify away from equity ETFs, which tend to carry a higher risk. Bonds offer more price stability than stocks with low correlation to stock market movements. 

Bond ETFs are more accessible to individual investors, as the bond market can be opaque with a variety of types of bonds, whereas ETFs offer immediate access to a portfolio of bonds. Bond ETFs pay out the interest they receive on the bonds in the portfolio. Investors can target their bond exposure, with short-term, intermediate-term and long-term ETFs.

• Commodity ETFs

Commodity ETFs allow investors to gain access to liquid and volatile commodity markets, like oil, gold, copper or coffee, which were previously limited to commodities traders registered with exchanges. Commodity ETFs are often based on derivatives, rather than the physical asset, so can carry a higher risk.

• Currency ETFs

Currency exchange traded funds track a single currency or a basket of currencies, such as the US Dollar Index (DXY). Some ETFs trade a currency directly, while others trade derivatives or a combination. Currency ETFs allow investors to hedge their portfolios against currency volatility.

• Speciality ETFs

Speciality ETFs, such as leveraged ETFs and inverse ETFs, are funds designed for short-term ETFs trading with a higher risk versus reward potential. Leveraged ETFs borrow money to invest additional funds, typically two or three times the initial investment. Please note that leverage can magnify both profits and losses. Inverse ETFs move in the opposite direction to the benchmark index, allowing investors to potentially make money if an asset falls in value.

• Factor ETFs

Factor ETFs focus on specific market drivers, and are often used by institutional investors and active managers. For example, value ETFs are biassed towards stocks that represent high price to value ratio in terms of their fundamentals and the potential for share price growth, while momentum ETFs hold stocks that demonstrate rising volume on an increasing share price.

• Sustainable ETFs

Sustainable ETFs focus on investing in stocks that demonstrate high environmental, social and governance (ESG) standards. Sustainable ETFs aim to eliminate exposure to controversial business practices that do not align with an investor's values.

• Geographic ETFs

Geographic ETFs allow investors to diversify into stocks in other countries or regions that their broker does not offer for trading individually. This has become particularly attractive with the growth of emerging markets.

Difference between ETFs, index funds and mutual funds

What are the differences between an ETF vs a mutual fund vs an index fund? 

The term ‘mutual fund’ refers to the way a fund is structured. Investors ‘mutually’ pool their resources to invest in the market. Rather than trading shares in the securities held in the fund, investors buy and sell shares in the mutual fund company.

Index funds are a type of fund that aims to replicate the performance of a specific stock market index, while mutual funds are actively managed and aim to outperform the index. An index fund can be structured as a mutual fund or an ETF.

ETFs were developed to provide investors with a more tax-efficient alternative to mutual funds with higher liquidity. Mutual funds are bought directly from the fund manager and prices are settled only once a day. ETFs are marketable securities that can be bought and sold on stock exchanges instantly throughout a trading session. This allows investors to react quickly to market trends.

ETFs offer a flexible, lower-cost alternative to mutual funds, as passive index-based funds have lower management fees than actively managed funds. ETFs act like stocks in that they can typically be sold short, bought on margin, and offer options. 

ETFs share some common features with mutual funds – both are made up of a diversified basket of securities – but, typically, they don’t require a minimum investment, as most mutual funds do. ETFs usually offer lower expense ratios and broker fees.

What moves ETF prices?

The underlying value of the portfolio holdings, known as the net asset value (NAV), is the main price driver of ETFs. There can be differences during periods of heightened market volatility. 

The ETF price fluctuates throughout a trading session, while the NAV reflects the official value of the ETF, which is settled once daily, based on the closing prices for the underlying assets. The NAV is used to measure the performance of an ETF against its benchmark.

Supply and demand

The market price for an ETF is determined by the value of its holdings as well as supply and demand for the fund. The price fluctuates throughout the day as buyers and sellers execute trades. If demand rises, the price will move higher, and if it falls, the price will decrease.

Currency movements

Currency fluctuations can have an impact on the value of ETFs that invest in foreign markets. Changes in the value of a local currency can affect the price of stocks listed on overseas stock exchanges, increasing or decreasing any return on the asset. 

Currency fluctuations also have an impact on the profits of multinational companies that operate in different countries, which can affect the prices of underlying stocks in an ETF. Currency ETFs are designed to capitalise on and hedge against currency movements.

Economics

Economic trends can affect ETF prices, as strong growth can drive up the value of underlying assets, while a national or global recession can push prices lower. 

Some sectors can be more exposed to economic trends than others, like electric vehicle ETFs that invest in the clean energy transition. In another example, consumer staples ETFs aim to provide investors with stability by investing in companies placed to perform well even during recessions.

How to trade ETFs

There are different ways of trading ETFs depending on your experience, risk tolerance and preferred trading strategy.

Contracts for difference (CFDs)

One of the most popular ways to trade ETFs is using contracts for difference (CFDs). A CFD is a contract between a broker and a trader, where one party agrees to pay the other the difference in the value of an asset or security. 

The ETF trader aims to potentially make a profit from the difference between the price of the asset when they open and close the trade, although there is always the risk of loss. ETF trading using CFDs allows you speculate on the direction of the ETF price without actually owning it. 

With CFDs, you can trade ETFs in both directions. If you think an ETF price will rise, you can take a long position, whereas if you think the price will fall, you can take a short position. 

Options

ETF options are derivative contracts linked to futures prices, allowing you to take a position without the obligation to buy or sell the contract on the specified expiry date. 

When you buy an options contract, you agree to a strike price at a premium or discount to the futures price. You profit from the trade if the futures price moves toward the strike price by the expiry date, but lose the premium if the futures price moves away from the strike price.

Futures

Futures contracts enable investors to speculate on an asset’s price on a specified date in the future. These contracts differ from options and CFDs in that they obligate the buyer to take ownership of the asset or roll the contract forward on the expiry date. ETF providers often purchase futures contracts for their portfolio holdings, particularly commodity ETFs. 

Stock exchanges

If you want to own shares in an ETF at the current market price, rather than speculate on its future value, you can buy ETFs directly on stock exchanges in the same way as company stocks.

What is an ETF trading strategy?

Once you’ve decided to invest in ETFs, you need to form your investing strategy. There are several different ETF trading strategies you can use, depending on your preferred approach, risk tolerance, timeframe and overall trading or investing goals.

Dollar-cost averaging

By purchasing an asset like an ETF on a regular basis, you can average out the price you pay over time as the price fluctuates. 

Rather than making a single investment at a certain price, you can invest the same amount at regular intervals. This can reduce your average purchase price over time, allowing you to take advantage of market dips to turn a profit, although there is always the risk of making a loss.

Asset allocation

ETFs can make it easier for investors to construct their portfolios when starting out and rebalance over time. An investor can allocate a portion of their portfolio to a specific sector, such as technology or consumer staples, or to a specific asset class, like bonds or commodities.

Swing trading

Swing trades capitalise on large swings in an asset’s price. ETFs can be suitable for this as they have tight bid and ask spreads, so the difference in price does not get lost in the spread. 

Traders can choose to swing trade an ETF that covers a specific industry or asset class that they have particular knowledge of, allowing them to identify drivers for large price movements. Note that swing trading is typically a short and medium-term strategy.

Sector rotation

Investors often rotate their holdings into and out of specific industries, depending on economic trends. During times of strong economic growth, they might choose to focus on high-growth stocks, but when economies slow down, they rotate out of growth stocks and into value stocks.

If an investor’s portfolio becomes overweight in a specific sector, they can sell some of their ETF holdings to invest in a different sector so the portfolio does not become overly concentrated.

Short selling

Short selling is a high-risk strategy that involves borrowing a financial instrument or security to sell it. Short selling ETFs carries lower borrowing costs than individual assets and lower risk of a short squeeze, when a heavily shorted asset price spikes higher as traders are forced to cover their positions. 

Short selling ETFs enables traders to speculate on broad trends. For example, a trader expecting growth in emerging markets to slow down could short an emerging markets ETF.

Seasonal trend trading

ETFs can provide a convenient way for traders to potentially capitalise on seasonal changes in asset prices. Although, as with all trading strategies there is always a risk that they could lose their capital.

For example, gold prices tend to rise in the autumn and winter on higher demand for jewellery from India and China during festivals and holidays. 

Energy prices tend to rise during the winter when demand for heating is higher, or during the summer when air conditioning use peaks.

Hedging

ETFs offer investors a simple way to hedge their portfolios against downside risk. They are one of the easiest ways to invest in commodities like precious metals, which provide a hedge against economic uncertainty, rising inflation and low interest rates. 

While advanced investors can trade put options on specific securities to hedge their portfolios, ETFs make it straightforward to take a short position on a certain sector or the broader market.

Depending on your circumstances, you can choose a combination of ETF investing strategies.

How to trade ETFs with CFDs

Are you interested in trading ETFs with CFDs? Using CFDs to trade ETFs allows you to gain exposure to short-term price fluctuations in specific sectors or countries. Trading CFDs allows you to use leverage to amplify your exposure to the ETF, so you can open a bigger position with a smaller deposit. Remember that leverage can magnify both profits and losses.

If you want to start ETFs trading using CFDs, sign up for an account with a CFD provider like Capital.com. You can trade ETF CFDs along with CFDs of commodities, stocks and forex in the same account.

To get started, you can follow these simple steps:

1. Create and login to your CFD trading account

2. Choose which ETF you want to trade

3. Use your preferred trading strategy to identify trading ideas

4. Open your first trade. You can set a stop loss or a guaranteed stop loss to manage risk

5. Monitor your trade using technical indicators and fundamental analysis

6. Close your position in line with your trading strategy

Pros and cons of trading ETFs with CFDs

Trading ETFs with CFDs offers gaining diversified exposure to a basket of assets without having to carry out research on individual components. You can use ETFs to take positions on broad trends such as seasonal changes, sector rotation, or economic performance in a particular country. 

CFDs provide flexibility to trade in both directions. Whether you have a bullish or bearish view of an ETF price, you can speculate on either upwards or downward price movement. CFDs use leverage so that you can take a large position with only a small initial investment of capital. 

For example, a  10% margin means that you have to deposit only 10% of the value of the trade you want to open, and the rest is covered by your CFD provider. If you want to place a trade for $1,000 worth of CFDs and your broker requires 10% margin, you will need only $100 as the initial capital to open the trade.

However, you should be aware that trading CFDs also carries risks as they are leveraged products that multiply the size of losses if the price moves against your position, as well as maximising gains if the price moves in the same direction. It is important to do your own research and understand how leverage works and  before you start ETF trading with CFDs. 

Note that CFDs also imply overnight fees, meaning that they are more appropriate for short-term ETF trading, rather than long-term investing. 

Why trade ETFs with Capital.com

If you are looking for how to trade ETFs using CFDs, Capital.com offers advanced features to enhance your strategy and generate better results.  

Advanced AI technology at its core: A personalised news feed provides users with unique content depending on their preferences. The neural network analyses in-app behaviour and suggests videos and articles that fit your trading strategy. This will help you to refine your approach when you trade ETF CFDs.

Trading on margin: Thanks to margin trading, Capital.com allows you to trade ETFs, and other top-traded assets, even with a limited amount of funds in your account. Keep in mind that CFDs are leveraged products, which means both profits and losses can be magnified. 

Trading the difference: By trading ETFs with CFDs, you do not buy the underlying asset itself. You only speculate on the rise or fall of its price. A CFD trader can go short or long, set stop and limit orders, and apply trading scenarios that align with their objectives. CFD trading is no different from traditional trading in terms of its associated strategies. However, CFD trading is short-term in nature, due to overnight charges. Plus, there are extra risks associated with leverage as it can magnify both profits and losses.

All-round trading analysis: The browser-based platform allows traders to shape their own market analysis and forecasts with sleek technical indicators. Capital.com provides live market updates and various chart formats, available on desktop, iOS and Android.

ETF trading hours

If you are going to start trading ETFs you need to be aware of the market’s working hours. An ETF’s trading time is the same as that of the stock exchange where the ETF is listed. 

For example, the ETF market open time for a US-listed fund is 09:30 to 16:00 EST. Some broker platforms offer pre-market or after-hours trading, allowing you to buy and sell stocks and ETFs a few hours before or after the market opens and closes.

At Capital.com, ETF CFDs are available for trading depending on the asset. You can always check an ETF’s trading hours on its market page on our website or mobile platform. For example, ​​SPDR S&P 500 ETF Trust (SPY) CFDs are traded from Monday to Friday, 13:30 - 20:00 (UTC).

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