Chapter 5
Trading Futures Through the Side Door
In This Chapter
Getting the lowdown on exchange-traded funds (ETFs)
Trading stock indexes with ETFs
Speculating on commodities like energy and metals
Seeing the value in currency ETFs
Gaining insight from real-life examples
With exchange-traded funds (ETFs), the world of the futures markets has opened to traders whose fears of the unknown previously limited their prospects. When you understand ETFs and how to make them work successfully, you can trade just about anything.
This chapter helps you get your feet wet in futures trading through ETFs, which means you can trade without worrying about margin and when to roll over a contract.
Using the information and techniques in this chapter, you can participate in the general trends of the futures markets, including the agricultural, energy, bond, currency, and stock index futures contracts, with less threatening instruments. In other words, ETFs are instruments that let you take advantage of the overall profit potential of the futures markets without having to open a separate account for your trades.
Here are some of the things that I like best about ETFs:
I can trade the trend, up or down, without having to research individual stocks. Thus, I can participate in what’s happening as I make more detailed decisions about further trades.
I can trade them through my online account with a click of my mouse, just as if I am buying individual stocks.
I can trade anything from stock indexes to commodities, bonds, oil, natural gas, currencies, or very specific sectors in the stock market.
The basic trading techniques are also applicable to the more familiar futures markets, such as bonds, commodities, oil, and natural gas. In other words, when conditions are right to buy an oil ETF, they are also right for buying oil futures. So after you master the techniques required to trade these ETFs, you can use them as a basis to trade futures directly.
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Introducing Exchange-Traded Funds
ETFs are mutual funds that trade like stocks. These clever and useful instruments
Trade during the entire trading day and during extended market hours. This property lets you trade these vehicles when and where you want to. They’re even suitable for day trading. Mutual funds, on the other hand, can usually be bought at the end of the day and can’t be sold until the close of the market on the next day.
Have specific qualities. For example, the Powershares Nasdaq 100 ETF (QQQQ) can be bought or sold for 15 minutes after the stock market closes. These ETFs resume trading after a brief period of time in the after-hours session.
Behave similarly to the index, commodity, or portfolio that they’re patterned after. For example, the U.S. Oil Fund (USO) has a similar trading pattern and follows the same general price trend as crude oil.
Offer both the opportunity to go long or go short the market, without having to sell shares of stock or of an ETF short, although you can sell shares of any individual ETF short. See next bullet. For example, you can go long the Nasdaq 100 index by owning the QQQQ ETF. To short the Nasdaq 100, you can just buy shares of the Ultrashort QQQ Proshares (QID) or a similar fund. See “Stocking Up on Stock Index Future ETFs,” later in this chapter.
Can be individually sold short. If you prefer to sell short directly, you can sell any ETF short as you would any stock by borrowing shares from your broker in a margin account. Although that’s possible, I recommend shorting the market by buying an ETF that sells short rather than shorting an ETF that goes long.
Offer options trading similar to stocks and futures. You can trade ETF options as you would trade stock options. In some ways, long-term options (LEAPS) are well suited for ETFs. LEAPS let you bet on the long-term price of an underlying instrument, such as a stock. See Trading Options For Dummies by George A. Fontanills (Wiley) for full details on LEAPS and other options.
However, not all ETFs are created equal. Reading the fine print about how an ETF goes about its business is important. The Macroshare Funds for trading crude oil are an example. These funds use derivative formulas based on the bond market to mimic the action in the oil market. See “Comfort via Commodity ETFs,” later in this chapter for more details.
Stocking Up on Stock Index Future ETFs
You can trade just about every single stock index by using an exchange-traded fund. But for the sake of simplicity, I concentrate on the big ones because a big part of your success here depends on liquidity and ease of trading as well as your own recognition of what you’re trading. The indexes in the following sections all have corresponding futures contracts. After you get the hang of working with these, you can expand your horizons.
Futures are meant to be traded both short and long, so I list any short-selling funds that are available for any particular futures market in this section. If no fund is listed, it’s because no ETF that specialized in short selling that particular market or index was available at the time. Also, due to space limitations, I limit my discussion to the most liquid ETFs.
In the following sections, I discuss the most liquid and actively traded major stock indexes and their corresponding futures contracts.
The S&P 500 (SPX)
The S&P 500 and its ETFs are important because the action in these ETFs closely matches that of the S&P 500 index futures, at least in their general direction and the size of the moves.
SPDR S&P 500 (SPY): This highly recognizable and well-advertised ETF is the most commonly traded S&P 500 ETF. Also known as the S&P 500 “Spyders,” it is among the most liquid of all ETFs. SPY trades at one-tenth the value of the S&P 500 cash index. That means that if the S&P 500 is at 1,400, SPY trades at 140. SPY works well when you want to trade the overall trend of the broad stock market.
Ultra S&P 500 Shares (SSO): This is a leveraged ETF which rises and falls twofold the daily performance of the S&P 500. It’s an excellent fund when the market is starting to come out of a significant decline. The potential risk of losing twice the drop of the S&P 500 on any given day, though, makes it a tough one to use until a rising trend is clearly in progress.
Short S&P 500 ProShares (SH): This ETF is a way to sell the S&P 500 short without selling SPY short. SH is structured to work opposite to the S&P 500, without any leverage. In other words, if the S&P 500 was to lose 1 percent at any given time, SH would rise close to 1 percent.
UltraShort S&P 500 ProShares (SDS): This is my favorite way to sell the stock market short because it follows the trend of the S&P 500 quite closely, and it gives me the opportunity to leverage my gains. The investment goal of this fund is to deliver twice the opposite performance of the S&P 500 (200percent), before fees and expenses. I use it when I get sell signals for the stock market. See Chapter 12 for more detail on stocking up on indexes. See “Using ETFs in Real Trading” at the end of this chapter for a real-life trading example.
The Nasdaq 100 Index (NDX)
The Nasdaq 100 Index is a basket of large technology stocks including familiar names such as Intel and Apple. The index often moves in a big way, both up and down, offering great opportunities for active trading.
PowerShares Trust (QQQQ): This highly popular and liquid ETF contains the largest 100 stocks that trade on the Nasdaq. It works well as a proxy for the Nasdaq 100 futures and the E-mini Nasdaq futures, which are both very popular contracts.
Ultra QQQ Proshares (QLD): This ETF is designed to double the returns of the Nasdaq 100 Index twofold. It’s a good vehicle to use when you’re expecting a significant rally and want to get more bang for your buck. Just remember that what goes up twofold also falls twofold.
Short QQQ Proshares (PSQ): This ETF shorts the Nasdaq 100 Index on a one-to-one basis, such that a 1 percent drop in the index leads roughly to a 1 percent rise in the price of PSQ. This fund is ideal if you want to sell NDX short but aren’t willing to get too leveraged.
UltraShort QQQ ProShares (QID): As with all “Ultra” funds, this one gives you a twofold return on the trend of the index that it mirrors. In this case, QID rises twice the amount of the Nasdaq 100 when the index falls. This is an excellent fund to use when large technology stocks are having difficulties and you’re looking to leverage your short positions.
The Dow Jones Industrial Average
The Dow Jones Industrial Average is the most widely followed stock index in the world. Its corresponding ETFs are great trading tools, and they have an excellent correlation to the Dow Jones Industrial Average futures.
Diamond Shares (DIA): This is the way to trade the general trend of the Dow Jones Industrial Average. Its value is roughly one-tenth of the Dow Jones Industrial Average.
DDM, DOG, and DXD: Ultra Dow30 Proshares (DDM), Short Dow30 Proshares (DOG) and UltraShort Dow30 Proshares (DXD) round out the quartet of highly liquid Dow Jones Industrial average–based ETFs. As with other Ultra ETFs, the ones corresponding to the Dow Jones Industrial Average are leveraged. To short the Dow Jones Industrial Average on a one-to-one basis, use the Short Dow30 Proshares (DOG).
Comfort via Commodity ETFs
Commodities, at least as of February 2008, seem to be in the midst of a multiyear, and perhaps a multidecade, bull market. Indeed, even dummies (like us) can trade oil, natural gas, commodities like wheat and soybeans, and bonds with little trouble as long as we have online stock trading accounts.
Still, it’s a good idea to check out Chapter 10 for information on trading bonds, see Chapter 13 to get a good idea as to what’s involved in trading energy, and review Chapter 16 to get the lay of the land on agricultural commodities before you jump in with both feet. Other chapters that are likely to be helpful in trading ETFs include Chapter 7 (on technical analysis), Chapter 14 (on trading metals) and Chapter 17 (on setting up your trading plan).
Energizing your ETF Trades
The energy markets captured the spotlight for the last seven years, since oil began its climb before topping out at $110 in March 2008. Whether that’s the final top or not remains to be seen, but one thing is certain: The energy markets offer great trading opportunities, and there are plenty of ETFs that you can use to participate.
The U.S. Oil Fund (USO): This was the first ETF introduced to allow the actual trade of crude oil futures without owning futures contracts. It remains the most liquid, although it has some competitors. The key to success is to remember that USO follows the general price trend of crude oil, but the price is not the same as the leading crude oil futures.
As Russell Wild points out in Exchange-Traded Funds For Dummies (Wiley), USO is a commodity pool. It doesn’t invest in oil companies, but rather in crude oil futures. Thus, it’s a risky and volatile fund, whose value is based on the value of the futures contracts owned by the management company that runs the fund.
Wild goes to great lengths to give you the negative aspects of the ETF, and they’re worth reading so you get the whole picture. But for my money, the fund, which has been around since 2006, is very liquid and serves my purposes as it follows the trend of crude oil futures closely. When oil prices are rising, I want to own shares in USO.
The PowerShares DB Energy Fund (DBE): This fund lets you trade West Texas Light Sweet Crude oil, Brent Crude, RBOB gasoline, heating oil, and natural gas under one banner. The problem with the fund is that there is no guarantee that all five energy components will be in bullish or bearish trends at the same time. As a result, this ETF may lag a single commodity fund such as USO or UNG. Still, if the energy sector is firing on all cylinders, this one is a good one. Both crude grades get a 22.5 percent weighing here, as do gasoline and heating oil. The more volatile natural gas component gets a 10 percent weighing.
Macroshares Oil Down Tradeable shares (DCR): This ETF has not been very successful given its inability to track the price of crude oil, either in price itself or in percentage terms. Much of the problem has been the illiquidity of the product. On some days, only a few hundred shares trade hands, in contrast with USO, where hundreds of thousands of shares trade daily.
The problem with Macroshares DCR is that the fund is not invested in the short sale of oil or oil futures; rather, it’s invested in treasury bonds, which in turn are worked into a formula that’s supposed to generally track the trend of crude oil. If this fund worked correctly, it would rise in price when crude oil prices fall. But it doesn’t always work that way. In fact, on January 17, 2007, the price of crude oil fell and DCR shares fell. Aside from embarrassing the issuer of the fund at the time (Claymore Advisors), the incident raised questions about whether this fund would be viable.
Nevertheless, knowing about it is worthwhile, assuming it stays around. As of February 2008, the fund was still available. And if oil ever falls for any extended period of time, this might be a good way to try to make money from the event, after careful scrutiny of how the fund is functioning at the time.
The United States Gas Fund (UNG): UNG actually works pretty well at moving along with the fortunes of natural gas. It correlates with the rises and falls of the price of the underlying futures. The major problem with UNG is the fact that natural gas is hugely volatile. So even in an ETF you could experience big intraday volatility. I have traded this fund many times and have had a difficult time making money, due to the nature of the underlying asset. Yet, if natural gas ever hits a bull market like crude oil has had since 2001, this would be a good way to play it.
The PowerShares DB Commodity Index Tracking Fund
(DBC): This fund tracks a diversified commodity portfolio, including crude oil, heating oil, aluminum, corn, wheat, and gold. It generally tracks the overall price of the commodities it houses, but is heavily weighted toward energy with crude oil (35 percent) and heating oil (25 percent) making up over half of the asset allocation. Aluminum accounts for 12.5 percent, while corn, wheat, and gold make up the rest of the fund. Make no mistake about it, though; despite the diversification, this is no wallflower of an ETF.
The PowerShares DB Agriculture Fund
(DBA): This is a good play on the agricultural commodities. It’s designed to track, before fees and expenses, the Deutsche Bank Liquid Commodity Index — Optimum Yield Agriculture Excess Return. DBA tracks the price of corn, wheat, soybeans, and sugar with each commodity getting a 25 percent weighing in the ETF. It functions similarly to DBC, but is more volatile since it concentrates its assets on agriculture. Both DBA and DBC were doing well in early 2008, as commodities were rising in price due to higher demand for goods in China and other emerging markets. Both DBA and DBC are direct commodity pools.
The golden touch — metal ETFs
Precious metal ETFs are fairly liquid and trend with the price of the underlying commodity quite well. Several fairly liquid gold funds exist, but the most liquid and most popular is Streettracks Gold Shares (GLD). This fund offers access to gold bullion without having to trade futures or take custody of bullion bars. It also saves transaction fees.
Other gold and silver ETFs are
PowerShares DB Precious Metals (DBP), which houses both gold and silver futures. Gold makes up 80 percent of the portfolio, with silver carrying 20 percent of the load. This makes sense, given the volatility of the silver market.
PowerShares DB Gold Fund (DGL) and iShares DB Silver Trust (SLV) are self-explanatory.
The PowerShares DB Base Metals Fund (DBB) lets you trade aluminum, zinc, and copper. Each represents 33.3 percent of the portfolio. This is a good fund when the global economy is booming and demand for industrial metals is high.
Getting Current with Currency ETFs
Foreign currencies are an excellent way to profit from global market volatility, political instability, and other crises. At the same time, they’re excellent trading vehicles when interest rates change.
A good general rule is that higher interest rates and a strong economy tend to favor a country’s currency. And while there isn’t a 100 percent correlation between any one variable and a currency’s price, if you know how to trade with the trend, currencies are an excellent vehicle. For the whole story on currencies, read Chapter 11. In this section, I provide a good list of currency ETFs. All of them trade along the same trends as their underlying currencies.
There are plenty of opportunities to trade currencies via ETFs:
You can bet on a rising U.S. dollar with the PowerShares DB U.S. Dollar Bullish Fund (UUP). This ETF has relatively low volatility and is not the best way to trade the dollar when the trend is sideways because it generally rises and falls with the U.S. Dollar Index, a slow-moving composite of the dollar against ten global currencies.
The same can be said about the PowerShares DB U.S. Dollar Bearish Fund (UDN). This would be a good way to trade the dollar in a very long-term downtrend, but it has fairly low volatility and is not as good a vehicle for trading as are the individual currency funds that I describe in the next two bullets.
The Currency Shares EuroTrust (FXE) has an excellent correlation to the exchange rate between the euro and the U.S. dollar.
The Currency Shares Swiss Franc Trust (FXF), the Currency Shares Australian Dollar Trust (FXA), the Currency Shares Yen Trust (FXY), the Currency Shares Swedish Krona (FXS), the Currency Shares Canadian Dollar Trust (FXC), the Currency Shares Mexican Peso Trust (FXM), and the Currency Shares British Pound Trust (FXB) round out the ETF offerings for the currency markets.
For more information on these ETFs, visit www.currencyshares.com.
Using ETFs in Real Trading
In this final section I describe a real trade that I recommended at www.joe-duarte.com, and that I made in my own portfolio at the same time. In order to illustrate both the concept of trading futures and how to use an ETF in the process, I chose a sale in which I shorted the UltraShort S&P 500 ProShares (SDS).
The market had been acting fairly poorly since the start of January, but by January 15, (2008) things were getting pretty dicey. On December 26, 2007, on Joe-Duarte.com I recommended the purchase of S&P 500 SPDRs (SPY), which was triggered at 149.53. The trade moved mostly sideways, which is rare for the week between Christmas and New Year’s Eve. Traditionally, the holiday week is one of the best trading weeks of the year, as portfolio managers tend to “window dress” their portfolios by adding more shares of winners and making their results look better. Figure 5-1 shows the uncharacteristically flat market during the holiday period in 2007 and the subsequent decline as well as the catalysts of the decline in early 2008.
On January 4, 2008, I recommended the purchase of SDS on a price above 60.05, as the S&P 500, which had crossed below its 200-day moving average at the end of 2007, looked to weaken once again. (See Chapter 7 for more on the 200-day moving average.) The market stayed that way until January 10, when it rallied briefly and again tried to stabilize. Figure 5-2 shows the entry and exit points for the trade.
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Figure 5-1: The S&P 500 failing to rally and finally breaking down during the traditionally bullish holiday period. |
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Figure 5-2: ProShares Ultrashort S&P 500 ETF entry and exit points during a short-term trade via the short-selling ETF. |
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But the stabilization process of the S&P 500 (refer to Figure 5-1) looked weak, as volume dried up on each day thereafter. Weaker volume on a rally is usually a sign of poor conviction. As I saw this phenomenon and noted that the market was still trading below its 200-day moving average, the dividing line between bullish and bearish trends, I recommended entering SDS on a price above 60.05.
The entry point on SDS was triggered on January 15, when the market started selling off during the middle of the day. This was due to several announcements made by Apple Inc.’s CEO Steve Jobs during a news conference. The news did not sit well with traders, who were already jittery about the general state of affairs.
The stock market drifted off for the rest of the day, and all hell broke loose after the bell when Intel’s earnings announcement again disappointed the street. The S&P 500 started a five-session decline that finally stopped on January 23. The position was stopped out that day at 66.23, pocketing a 10.29 percent gain in an eight-day period.
Here are some other important things to note on Figures 5-1 and 5-2:
Note the generally inverse nature of the charts. This makes perfect sense as SDS is supposed to move in the opposite direction of SPX. It’s important for an ETF to do what it’s designed to do. In this case, SDS acted perfectly, as it rallied when the S & P 500 fell.
Note also that when SPX fell below its 200-day moving average, SDS moved above its 200-day line.
Next, look at the sideways action until the January 14 break in SPX, which corresponded to the breakout in SDS.
In other words, the key to this trade was to watch what happened in the S&P 500 and to be ready to pull the trigger on SDS.
To be sure, there is more to this trade than just watching the two instruments and the 200-day moving average. Yet, the key concept is that if you match an ETF to an index and you’re careful as well as decisive, you can make a nice profit over a relatively short period of time.
Other things to note:
It helps to be patient and to keep an eye on the overall trend of the markets. In this case, it was clearly down. It took this trade 11 days to materialize. I recommended the entry point of 60.05 on January 4, and waited until January 15 for the right circumstances to develop before the trade was actually triggered.
Next, it always pays to watch how the market responds to news. Steve Jobs (Apple’s CEO) didn’t really say anything too horrible during his keynote address at MacWorld; yet, the market sold off during his speech. When good news leads to selling, the market is weak and you should be looking to either get out or sell short.
Finally, you have to be disciplined when you sell as well as when you buy. When the market started to rally on January 23, it was time to sell, and we did.