When a market is having trouble and investors are concerned about a pullback, one of the ways to keep bringing in profits while affording some additional protection is often to turn to ETFs.
Many times ETFs will get beaten up as the underlying stocks within the ETF collapse under the selling pressure of a pullback. By selling puts or covered calls in an ETF during a strong pullback, you have a bit more protection in that a recovery or rebound, when it happens, often pushes the ETF back to various support levels. As well for many investors when a stock they have been trading against takes a strong plunge in a downturn, often they comprise part of an ETF and will not have impacted the entire ETF as much making it “safer” to keep the trade active but through the ETF rather than the plunging stock.
Just remember that “safer” is a term loosely used when it comes to ETFs. Many investors consider them a lot safer than individual stocks. This is not always the case. For example Duke Energy Stock is down 5.2% from its recent all-time high, while the XLU ETF is down 7.4% since it covers a wide basket of utility stocks, many of which have been plunging in the present market downturn. By staying with stocks that have strong balance sheets and widely held shares particularly institutional holdings, often a big cap stock will perform better than the underlying ETF. In fact many of the ETFs traded today are built around a handful of strong stocks and then all the remaining medium size or less “stellar” stocks are put into that same basket. The belief is that the ETF will hold up better by having the strong stocks support the weaker ones. So remember that the word “safe” often is used improperly when it comes to one stock versus a basket of stocks.
But in a downturn ETFs can often be the place to look. The smaller cap or medium cap stocks that are tossed into the basket of stocks that comprise an ETF often will collapse further and faster in a downturn pulling the ETF lower overall. But in a rebound rally such as we are seeing today, these small cap and medium cap stocks are snapped up by investors just because they are so beaten down. These investors are looking for a quick trade. They want to pick up these smaller capitalized stocks and know the chance of a big jump is better simply because they are so beaten down.
When a rebound rally occurs, often these smaller capitalized stocks will run up quickly and they help to stabilize and push up the underlying ETF. This also makes ETFs worthwhile for trading especially when they have plunged deeply in a strong pullback such as the present one.
The rest of this article and trade alert is for members.