Saturday, September 10, 2011

Choosing an index to trade?

In this blogpost, you will find
1, When do I prefer to trade individual stocks/ securities?
2, What ETFs do I use to trade? Which index do I prefer and why?
3, Can we use leveraged ETFs?

When VIX is below 20, I would like to trade individual stocks on an Intermediate term. When VIX is above 50, I would like to start nibbling at individual stocks increasing position size as VIX increases for the long term. When VIX is between 20 and 50, I am comfortable trading for the short term, more into ETFs. I defined my short term, Intermediate term, and Long term trades here.

If your total portfolio capital is small (say 5000$), trading ETFs will help as you need not be scared about volatile swings in the individual item and face loss. For example, if you have a stock XYZ in your portfolio, and that company posted bad news, earnings result, or downgrade by analyst, and it went down by 10%, you will face a haircut of 500$ which is significant for a 5,000$ capital. To make it back is not easy. I personally would be uncomfortable trading individual stocks if my capital is small. If you trade ETFs, you don't have to worry about news, patents, product releases, earnings reports, downgrades. If you trade ETFs, you can save time by analyzing the general market trend instead of going through all the above. Whether your capital is small or big, I prefer ETFs unless you have a compelling arguement where you stand by your own risk.

If I choose to trade the major indices, I prefer the SPX via SPY or the Russell 2000 index via IWM.

SPY and IWM match my preferences for
1, Being highly liquid: You always need to buy a stock or ETF which is highly liquid and highly traded. Highly traded means you have narrow bid x ask spread and which will give you a chance to get out at any point of time, even during extended hours - should there be a high gap up or down (for or against your position). Unless compelling and long term investment, you never want to be in a stock which doesn't trade much in extended hours. Our goal is to have control on every penny of our money, as much as we can.

2, Basket of stocks: SPY represents SPX which is an index of 500 stocks. SPX's price is not influenced by one of the stocks ever. Same with IWM. On the other hand, NASDAQ100 via QQQ has giant market cap names like AAPL, GOOG, QCOM, AMZN which form 50-60% of the index. One of those names can easily influence the sway to one side on major news on these companies which will mean that the technicals basing on which we buy or sell the index is thrown to the dustbin. In the same way, $DJI also consists of only 30 names which means one of them could easily influence the index.

I prefer SPY and IWM for that reason. If you are comfortable with a high beta, go with IWM. Otherwise SPY should just do fine. Great people master simple things perfectly, they don't master perfect things.

I don't recommend trading leveraged ETFs, I may trade on my own but that is at my own risk. If you see me buying TNA (which is 3x daily bullish IWM), then my recomendation would be for you to buy IWM.

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