How Do Exchange-Traded Funds Work in Options Trading?
September 7, 2016
Similar to index funds, exchange-traded funds (ETFs) are securities that enable investors to purchase and sell them throughout the day like typical stocks.
The main purpose of ETFs is to make it easy to buy various securities in a single purchase. They are more convenient than mutual funds, with the same level of diversification.
How to Invest in ETF Shares
ETFs are some of the most useful and popular securities available in the market. Starting in 1993 with the Standard and Poor’s Deposit Receipt, ETF shares were typically called SPDR or “Spider.”
These funds gave investors the ability to mimic the S&P 500 without any need for index funds. They also behave similarly to stocks, enabling people to purchase and sell them on a daily basis, purchase them on margin, or short them.
Investors should keep in mind that they can’t buy shares directly through ETFs, but sponsors can sell large blocks of 50,000 or more “creation unit” shares, which an authorized participant can then buy.
These individuals may include institutional investors, specialists, or market makers who can place those shares in a trust prior to splitting them into ETFs and selling them via secondary markets.
Normally, investors sell ETFs to other investors buying in the open market, but investors also have the ability to collect and redeem them for single creation units, profiting on underlying securities, but the latter actions are typically avoided because of the large sum of shares that can be overwhelming and unmanageable.
Why Get ETFs?
ETFs have surged in popularity recently, with a growing number of offerings. Specific benefits of using ETFs include:
- More liquidity with mutual funds that allow investors to buy and sell hundreds of thousands to millions of ETFs at any time throughout the day
- Additional tax benefits with the ability to buy ETFs in the open market without any additional tax liability, along with payoff for redemptions via stock shares instead of cash
- Lower cost because of a lack of front- and back-end loads that investors see with traditional mutual funds, along with a lack of active management and no minimum investment requirements
These benefits can make ETFs an attractive option for many types of investors, but keep in mind that there are reasons you may want to stick with traditional mutual funds.
Determine if ETF Shares are Right for You
While ETFs can come with some advantages over traditional mutual funds, there are certain problems that investors may have with these funds.
The main problems with ETFs may apply to those who prefer active management, as ETFs are normally fixed, and each purchase also includes a brokerage commission when trading them as stocks, which may be too costly for some investors.
These disadvantages may be enough to keep certain investors away, but the benefits they offer may outweigh the downsides if investors need more than what traditional funds have to offer.
Taking into account how an ETF works and these shares’ pros and cons, you can decide whether or not to use them when investing.