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ETF Basics

ETF Basics

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Published by: G117 on Jan 19, 2010
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ETF Basics: What You Need to Know About Exchange-Traded Funds
By David Penn , On Monday January 18, 2010, 7:41 am ESTExchange-traded funds (ETFs) are an excellent way to trade markets in the short term or invest inthem for the long term. ETFs are so versatile that a growing number of people from professionaltraders to the average investor are learning about how to trade and invest in exchange-tradedfunds. ETFs can be bought and sold as easily as stocks. And like mutual funds, ETFs can provideexposure to whole markets like the S&P 500, individual sectors like technology or oil companystocks, even the stock markets of entire countries like China or Brazil. Commodity and currencyETFs make it possible for ETF traders to trade and invest in markets once available only to forexor futures traders.Because ETFs can be traded like stocks, ETF trading is an increasingly popular way for traders totake advantage of a wide variety of markets as they pull back to new lows or breakout to newhighs, providing potential opportunities for traders of all kinds. In our upcoming book, HighProbability ETF Trading Strategies, we will share with you some of our best strategies foridentifying high probability ETF trading opportunities in the market every day.But before you wade into the ETF waters, be sure you know what ETFs are all about: what theyare made of, how they work and, as you will learn in, High Probability ETF Trading Strategies,how to trade them. Here are some frequently asked questions to help get your introduction (orrefresher course!) to ETFs started.
What are ETFs?
 Exchange-traded funds are investment products that allow investors and traders to buy or sellwhole indexes, sectors, international stock markets, as well as a wide and growing variety of securities from currencies to commodities. Because ETFs behave much like stocks and are tradedon the same exchanges as stocks, exchange-traded funds have become an increasingly popularway for institutional and retail investors and traders to gain diversified exposure to far moremarkets less expensively than might be the case if the same exposure was sought using mutualfunds, stocks, options or even futures contracts.
The very first exchange-traded fund (ETF) was the
(AMEX:SPY - News
),which were first created in 1993 as the Standard and Poor's Depositary Receipts. The SPY is nowthe most widely traded ETF in the world.
What types of securites are in ETFs?
 Most exchange-traded funds consist of stocks. However innovation in exchange-traded funds hasled to ETFs that are composed of not just stocks but bonds, preferred securities, evencommodities and currencies.The term "exchange-traded fund" usually is reserved for those ETFs that consist of stocks.Similar products that consist of securities other than equities - such as commodities or currencies- are often referred to as exchange-traded notes (ETNs). This ETN category also includesexchange-traded products that are based on indexes like the CBOE Volatility Index that have nospecific underlying security.
How and where are ETFs traded? Can I trade ETFs from a regular stock brokerageaccount?
 Exchange-traded funds are traded on the major exchanges such as the NYSE and the Nasdaq. Thefact that ETFs are traded on the major exchanges along side stocks means that traders andinvestors can buy and sell exchange-traded funds using their regular stock or options brokerageaccounts.
 Exchange-traded funds allow traders and investors to take advantage of opportunities in sectors,as well as entire stock markets. ETFs such as the
 Energy Select Sector SPDRS ETF
(NYSE: XLE  - News), which includes among its holdings many of the largest oil companies, such as
 Exxon- Mobil 
(NYSE: XOM - News) and 
Chevron Corporation
(NYSE:CVX - News).
What are some of the most widely traded ETFs?
 Among the more widely traded exchange-traded funds are the
, the
Financial Select Sector SPDRS ETF
(NYSE:XLF-News), the
PowerShares QQQQ ETF
), the
ProShares Ultra Financials ETF
(NYSE:UYG-News), and the
iShares Russell 2000 Index ETF
Are ETFs for trading, investing, hedging or all of the above?
 Exchange-traded funds are popular securities used by everyone from long term investors andshort term traders. Many ETFs, such as the S&P 500 SPDRS, are used by long term investors,many of whom prefer their low cost to similar products like no-load index mutual funds. On theother hand, leveraged exchange-traded funds - such as those offered by ProShares, Rydex andDirexion - are better suited for short-term traders who are better positioned to take full advantageof the 2x or 3x daily returns sought by leveraged ETFs.
What are some of the benefits of using ETFs compared to stocks?
 One of the biggest benefits of investing and trading in ETFs is that exchange-traded funds helpinvestors and traders avoid single stock risk. Single stock risk refers to the potential for any onestock to create a disproportionate effect on a given stock portfolio. While a trader or investor whobuys a stock runs the risk that the stock could actually go to zero (not an unrealistic possibility inthe age of Bear Stearns and Lehman Brothers), a trader or investor who owns the XLF or theUYG - both exchange-traded funds that include a variety of stocks - is far less affected shouldone or even two of the stocks that are in their ETF collapse or, worse, fall to zero.
 Exchange-traded funds also give stock and ETF traders easy access and diversification in stocksand stock markets from around the world. One popular vehicle for trading and investing inChinese equities is the
iShares FTSE/Xinhua China 25 ETF
(NYSE:FXI - News).
What are some of the benefits of using ETFs compared to mutual funds?
 Low cost, transparency and flexibility are among some of the reasons why more and moreinvestors and traders are turning to exchange-traded funds and, in some cases, leaving theirmutual funds behind. Transaction costs for ETFs are typically much lower than those for mutualfunds. Those who own ETFs can also learn with a few mouse clicks exactly what their ETFsconsist of and in what proportion - something that is often not the case with many mutual funds.
What are leveraged ETFs?
 Leveraged exchange-traded funds offered by a number of ETF underwriters seek to producetwice or even three times the daily return of their underlying benchmark. Because the leverage in

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