The first asset class everyone learns about (at least those that have enough disposable income to invest) is stocks. This is in large part because the mainstream media in their reporting only mention the stock market, and sometimes the cash price of oil and gold are given a two-second review. This prime-time coverage, albeit small, gives the general public some very vague knowledge about this asset class. Additionally, most middle class individuals that work for a medium or large sized corporation are usually offered a retirement plan that invests in mutual funds or company stock. This opportunity also gives people general knowledge about how to buy stocks or mutual funds, but very little in the way markets really work.
One of the advantages of trading stocks is that there are a wide variety of sectors and stocks that one can look at. And because some sectors react differently to the various economic cycles, this allows traders to have the versatility to diversify among the different stocks in each sector. There are some drawbacks to trading stocks as well, namely, the overnight risk. We refer to this as the gap risk. This happens because stocks only trade actively for six and a half hours and close for the balance of the day. These closings can have a dramatic effect on the opening price the following morning due to the vagaries the happen after the market closes. One way to avoid this risk is to flatten out stock positions at the end of every day and start anew each morning.
An alternative way to mitigate risk is to trade ETF’s. This acronym stands for Exchange-traded fund because these investment vehicles are indeed closed end mutual funds. They differ from traditional open ended mutual funds in that they trade exactly like a stock. Another distinction is that EFT’s are designed to track broad based indexes such as the S&P 500 (SPY) or the Nasdaq 100 (QQQ), as well as specific sectors of the economy such as the Financial sector (XLF) . These funds can also track certain popular commodities such as gold (GLD) or oil (USO) . Although ETF’s have been in existence since the mid-nineties they have only exploded in their popularity in the last ten years or so. They reduce risk because of their diversification, and while they still will gap, on balance; the percentages will be much less than those of individual stocks.
I’m often asked by students if understanding the futures market can provide an odds enhancer for trading individual stocks, and particularly ETF’s. The answer is yes. Because the futures markets trade around the clock, unlike stocks, the overnight activity can be useful in many ways to the stock trader. Large moves in the stock index futures during the European session create gaps in individual stocks, and ETF’s. These in turn provide opportunities for experienced traders in the early going of the New York session. One other advantage for the trader involved in ETF’s is that when a gap is created, most traders expect it to be filled or return to the prior day’s closing price, but quite often price turns inside the open space left on the chart of the stock or ETF. This is exactly what happened in the example below.
As we can see, the QQQ ( Nasdaq 100 tracker) traded slightly inside the gap, and immediately turned higher. Prices turned because there was a demand level that was formed in the Nasdaq futures market during the European session. The trader that was not watching the futures market probably anticipated the gap to be filled, and missed the trade. While the more astute trader probably made the trade because of the demand level showing in the Nasdaq futures contract.
This is just one example of how the futures market can give a stock or ETF trader an edge over their competition. Because in this highly competitive business of trading, having an edge can make the difference between winning and losing.
Until next time, I hope everyone has a great week.