A Trading strategy

MARKET MOVES

Exchange-traded funds can be used to trade real time and take advantage of sharp rises or falls.

A disclaimer at the very beginning... Traders have to factor-in market risks. Please gauge your risk-appetite before following such strategies.

PROFILING ETFS

Exchange Traded Funds (ETFs) are essentially Index funds that are listed and traded on exchanges like stocks

An ETF is a basket of stocks that reflects the composition of an index, like the s&P cnx nifty or the bse sensex

ETFs are cheaper than many other forms of investment

Short-term investors can take advantage by trading etfs during the day and at values which are very near to the net asset value(NAV)

With wild gyrations in the stock market in the past two months, all investors must be worried sick. However, while high volatility may lead to ulcers, it also creates windows of opportunity for those who are willing to take the plunge.

Some traders try to play this game through the futures and options segment and there are others who "keep the faith" on their stock selection abilities.

However, often when we say the "market" is volatile, we actually refer to index volatility. Hence, there is a case for using index-based Exchange Traded Funds (ETFs) to take advantage of the volatility.

The main reasons why such ETFs will suit traders are:

They can be easily bought or sold, like any other stock, on the exchange.

They can be bought or sold anytime during market hours, at a price close to the actual net asset value (NAV) of the scheme.

That basically implies that that you can immediately translate your view on the market into a trade. For instance, if on any given trading day, the NSE Nifty drops from 5,100 at 10 AM to 4,950 at 12:30 PM, and one believes that there is going to be a recovery during the market hours, an entry through an ETF at 12:30 PM is possible.

This is, unlike that in an index fund, where even if an order is placed at 12:30 PM, we will only know our entry NAV, based on the 3:30 PM index closing level.

And if you are unlucky, the index might well have clawed back to around 5,050, thereby reducing your profit margin. In this context, ETFs can be regarded as one of the tactical asset allocation tools.

Of course, this is a very short term description. The advantage can also be taken in a situation where the market has sharply fallen on a particular day and there are strong chances of a recovery, though slowly in the coming weeks.

An investor in ETF can enter the market on the "big fall" day and exit anytime he is comfortable with the level of the index.

There are other options like index funds that provide investors with similar exposure to the market, but their main disadvantage is that that they can only be purchased on an "end-of-day" NAV basis.

Also, there is the problem of "tracking error" in case of index funds, which is the shortfall between the performance of the underlying index and arises due to slippages on the part of fund managers.

In the case of ETFs, this error is virtually zero as they have an in-kind creation/redemption mechanism, which allows arbitrageurs to take advantage of any significant premium or discount, between the ETF market price and its NAV, by doing arbitrage between the ETF and its underlying index portfolio.

Other instruments like index futures also permit a market participant to translate his or her view immediately, the element of leverage involved in the transaction increases the risk involved.

ETFs on the other hand require full commitment of capital, although in the rare event of a day-trade in an ETF, one gets to pocket the difference.

In terms of trading costs, ETFs are subject to brokerage (around 100 basis points for around trip) and impact cost, [defined as (bid rate +ask rate)/ask rate] while index funds are subject to entry and exit loads.

As of date, most Indian index funds do not charge any entry load but charge an exit load of 50 basis points in case one exits before six months.

In case one day-trades in an ETF, the gains are treated as speculative gains and taxed accordingly. Other than this, both ETFs and index funds are taxed in a similar manner.

In the USA, several sector specific ETFs (the most widespread being the Sector SPDRs) are also actively traded. Benchmark Mutual Fund in India has filed for permission with SEBI to launch around a dozen sector specific ETFs on the National Stock Exchange.

They should be launched in a phased manner during this calendar year. Currently only the banking sector has a couple of ETFs.

To conclude, although the glamour of active trading is difficult to ignore, one must also be cognisant of the fact that one cannot predict every move in the market accurately. Hence only a small portion of one's investible surplus should be devoted to such tactical investments.