Posts tagged with: ETFs

Market orders, limit orders, stop-on-quote orders … what does it all mean?  In this episode, I start with the basics of order flow and execution: what happens behind the scenes when you buy or sell stocks and ETFs.  Then I go through the various order types, from simple to complex, to help you understand your choices.  You’ll get examples of situations where you might use one order type over another.


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Section 1: How Securities are Traded

Bid and ask prices

Market depth

Exchanges and other trading platforms

Order routing

National Best Bid and Offer (NBBO)

Price improvement

Brokers often get paid for order flow – is that fair or are we getting ripped off?

Section 2: Basic Orders and Conditions

Market orders

Limit orders

Conditions: All-or-nothing (AON), Fill or Kill, good ’till canceled (GTC), good ’till date (GTD), day orders, market on close (MOC), limit on close (LOC)

Stop orders


Trailing stops

Section 3: Complex Orders

One Cancels Other (OCO)

One Cancels All (OCA)

Conditional orders

Pegged orders



Scottrade: Anatomy of an Order (PDF)

TD Ameritrade: Order Execution FAQ

SEC Investor Publication – Trade Execution

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Think back to your most successful trades – the ones that made you jump out of your chair and run around the room, high-five your friend, enjoy a celebratory drink, or all of the above.  As traders, we all want more of this kind of trade.  In these moments, we feel like masters of the investment universe!

It takes lots of dedication and practice to achieve mastery, but it is not difficult to get started on the path towards success.  One of the critical first steps is defining what your investment universe will be.  After all, we can’t master something unless we first know what it is we want to master!

I call this mapping your investment universe.  It’s the process of deciding which markets you will follow and analyze, along with making a list of the securities you will trade.


Every Winning Plan Includes a Map of the Universe

In my earliest foundational post, I introduced a framework for building wealth entitled “The Five Components of Successful Investing”.

The five components are the blue boxes in this flowchart, taken from that post (with the blue circle added to mark today’s focus):


While the Universe of Securities box sits to the right of the other blue boxes, because it doesn’t need to be updated as often as the other components of successful investing, all the others depend on it.  We can’t make forecasts unless we have first chosen what types of investments (e.g. stocks, commodities, bonds) we want to forecast!  Also, most of us will use technical analysis of chart patterns to inform our trading decisions, which first requires us to select which charts we want to look at.

So, what should your investment universe be?  The answer is: it depends!  It depends on what YOU like to learn about, follow, and trade.  Some traders prefer to follow one industry, such as tech stocks or retailers, and get to know it in great depth.  These type of traders might define their universe as all the stocks in that sector, including small-cap stocks that they feel comfortable trading given their specialized knowledge.  Their universe might also include options or warrants on these stocks, depending on risk tolerance and other factors.

My approach to trading and investing is more broad than this.  It can be best categorized as “macro investing”.  Macro investing is all about trading a wide variety of assets and investment vehicles with the goal of capitalizing on large-scale trends and cycles.  I might buy a small-cap security if I think there is an opportunity there which aligns with a larger trend, but generally I am trading larger ETFs (exchange-traded funds) that hold a basket of securities in any given area.

I believe that macro investing is the optimal approach for most investors.  Here is why:

  • If your universe includes ALL the major asset classes, you’ll be able to take advantage of the best opportunities to bet alongside or against every area when it is becoming underpriced or overpriced, respectively.
  • Having a larger universe requires you to stay current on all the important trends, which makes you a better-informed trader.
  • Using ETFs as your primary investment vehicle, as opposed to individual stocks, provides better diversification within an asset class.

The exception to this would be if you have the time and desire to do lots of research on individual stocks, above and beyond the larger market trends.  In that case, you’d want to select stocks yourself for better returns and lower risk.  The vast majority of traders simply don’t have the kind of time needed in order to select stocks across many different sectors.

In the remainder of this post, I’ll explain how I map out my universe of securities.  This will serve as an example that you can adapt for your own situation.


Select Asset Classes

As I mentioned above, I try to include all categories of tradable assets in my investment universe.

First, I group them into major asset classes:

  • Currencies;
  • Precious Metals;
  • Commodities;
  • Bonds;
  • Equities (Stocks); and
  • Pure Derivatives.

Next, I further define “subclasses” within many of the asset classes.  For example, beneath Equities (Stocks) I have the ten market sectors (e.g. energy, utilities, financial services) along with mining stocks.  Beneath Commodities, I have: Soft Commodities, Base Metals, Oil, and Natural Gas.

Now that I’ve defined the scope of my universe, I can choose which securities I’ll trade.


Select Securities

To keep it simple, I choose only one preferred investment vehicle within each subclass.  Typically, this will be an ETF that tracks all major components of that subclass.  In some cases, there will be multiple “go-to” choices, as in the Currency Derivatives category where we can use UUP to trade the U.S. dollar, FXE to trade the euro, or FXY to trade the Japanese yen.

My list changes periodically as funds change and new choices become available.  Here is the list as of today:


My investment universe

These are the criteria I use to form the list, in order from highest to lowest priority:

  • Coverage (i.e. low tracking error);
  • High trading volume (i.e. low bid/ask spreads);
  • Low expense ratio;
  • Availability of options;
  • Trading volume in options.

I recommend you use some combination of the above criteria to form your own list, since your priorities might differ from mine.  For example, if you are a very frequent trader of options, the amount of trading volume in options could be your top priority.  In that event, you’d want to entirely remove the ETFs that don’t have high trading volume in options (e.g. DBA, DBB).


Follow Your Map, Unless You Are Absolutely Sure Where You’re Going!

Over 75% of my trading activity is in the ticker symbols found in my list.  I only deviate from the list when at least one of the following conditions hold:

  • I am trying to get more exposure outside the United States markets (e.g. I’m bearish on the dollar or U.S. markets have become overbought).  In this case, I’ll choose a fund with more foreign-listed stocks (like RWX instead of VNQ).  I keep a list of favorites.
  • Or, I’m trading a niche that is only a small piece of a subclass.  For instance, while uranium stocks are part of the energy sector they trade quite differently from the rest of the sector, which is dominated by oil and gas companies.
  • Or, I’ve thoroughly researched a company and am confident enough in my view of that firm that I’m willing to take on company-specific risk by trading it.

In the past, when I’ve strayed from my list by trading in different securities without one of these valid reasons, my results have been mediocre to poor.

I learned this lesson in the FactorShares 2x Gold Bull S&P 500 Bear ETF (FSG), an ETF that, mercifully, no longer exists.  From mid-2011 to mid-2012, this fund extracted over $9k from my account before the pain stopped.  I’d been buying it on the thesis that the ratio of the S&P 500 to gold would decrease.  As we see below ….


… it was a faceplant.  Ouch.  But although the ratio rose instead of falling as I’d expected, I suffered a bigger loss than necessary.  FSG wasn’t in my universe of securities, and I didn’t trade it for any of the three reasons listed above.  I used it because it looked on the surface like it tracked the ratio I wanted to trade.  I’d have been better off creating a synthetic long-short position with GLD and SPY instead of using this ill-contrived fund.

What I discovered later was that FSG was managed terribly.  Factor Capital Management, the managing owner of FSG and 4 similar ETFs, shut down its operations in 2013 and liquidated its funds, but not before:

  • Charging excess expenses above its stated 0.75% fee (already too high) which weren’t clearly disclosed in the fund’s prospectus;
  • Failing to provide required tax forms to investors before March 15 as required by law (I had to amend my taxes in 2012 because of them – what a pain!);
  • Failing to adequately promote its funds, which kept volume low and hurt the fund’s liquidity.

I shared this example because I don’t want to see you fall into the same trap.  Stick to your list of preferred funds only, and don’t deviate unless one of the three conditions in my list is true.

Macro investing can seem like too much to handle.  It can look like the universe is far too vast to navigate.  But make a map, stick to it, and you won’t get lost!  You’ll be ready to pounce on opportunities anywhere they appear, and you’ll be on the path towards mastering your investment universe.

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(CC image by Core Media Product Demo on Flickr)

(CC image by Core Media Product Demo on Flickr)


If you trade stocks, you’ve heard it before.  We all have.  From a colleague, family member, friend, or a mainstream investment advisor.

“You can’t beat the market.”  “Picking stocks is a fool’s game.”  “Stick to low-cost index funds.”  “Buy and hold for the long run.”

The list of prominent names who advocate for passive investing over active investing includes, to name just a few:

  • Jack Bogle, founder & former CEO of Vanguard Group;
  • Warren Buffett, founder & CEO of Berkshire Hathaway, who bet $1 million that a basket of 5 hedge funds would not beat an index fund;
  • Burton Malkiel, Princeton economist and author of Random Walk Down Wall Street;
  • Dave Ramsey, radio host and author of personal finance books including The Total Money Makeover. (Dave seems to be OK with actively managed funds, as long as you don’t do anything besides buy-and-hold the fund)

These folks would have us believe that the recipe for building wealth through investments is the following:

  1. Shovel money into low-cost indexed mutual funds and exchange-traded funds (ETFs) that mimic a broad market index, such as the S&P 500, FTSE 100, Euronext 100, DAX, or the S&P/ASX 200.  Or better yet, a global fund that includes all of them.
  2. Sit and wait for many years, while trying really hard not to look at your broker or retirement provider’s statements, lest you be tempted to sell.
  3. Retire rich.

Sounds simple, right?  It is!  Being somewhere between “mediocre” and “below average” isn’t too tough, if that’s your goal.

Why “below average”, not average?  If you hold a broad market index, aren’t you achieving the same return as the average market participant?



Why holding index funds puts you at a disadvantage

Some companies perform better financially than other companies.  (Duh!)

There are exceptionally well-run companies, terribly-run companies, and many in between.  As a passive investor, you’re the last to discover which are the good ones and which are the bad ones.  Active investors are constantly researching these firms to separate the wheat from the chaff.  Accordingly, they bid up the prices of the stronger ones and sell the shares of the weaker ones, so that over time their market values move in the right directions.  This process generally happens over a period of time, with the first movers getting the rewards for their work and the late movers stuck on sinking ships or chasing trendy companies that have already reached stratospheric levels.

Some companies are a disaster waiting to happen – a powder keg that will blow a hole in the value of your portfolio.  What if you could avoid them?

As an example, let’s examine the performance of the Energy Select SPDR Fund (XLE) starting with the major peak that occurred on July 24, 2014.  This fund is the largest ETF tracking the energy sector.

The chart below illustrates the XLE (the black line) and ten of its largest holdings (the colored lines) in 2014, all indexed to a starting value of 100 for clearer comparisons.  The XLE fell by over 40% to a low in January 2016, followed by a recovery of about half its losses.  However, all energy stocks are not created equal.  A sharp investor could have avoided the pain, or even experienced gains during this tumultuous period.


After initially being sold off alongside the rest of the sector, independent refiner Valero Energy (VLO) had vaulted to a gain of over 50% by the end of 2015, thanks to strong refining margins, low debt, and productive capital investments.  Refiners like Valero actually benefit from declines in the price of oil, the raw material for its refineries, as long as profit margins hold steady.

Other components of the XLE fared better than the index, including Exxon Mobil (XOL) (10% decline) and EOG Resources, Inc. (EOG) (15% decline) compared to a 29% decline in the XLE as a whole.

On the flip side, Chesapeake Energy (CHK) collapsed, shedding 90% of its value and dragging down the energy ETF along with it.  The natural gas producer suffered steep drops in the value of its shale assets, many of which could not produce at a profit as oil and gas prices plunged.  It continues to suffer under the burden of substantial debt.

You didn’t need to be a professional investor to see the potential for huge differences in how these companies would perform.  Two tools – (1) a simple stock screener filtering on debt levels and (2) an understanding of the basic differences between a refiner, pipeline company, an explorer, and a producer – would have helped you hang on to 15 or 20 percent of your investment that would otherwise have been lost in XLE.

But because index funds have all the stocks, and there tend to be more winners than losers, it all works out in the long run, right?  Wrong, because…

Most indexes are capitalization-weighted

What does this mean?  Each stock’s share in the fund is proportional to its market capitalization (the price per share multiplied by the number of shares outstanding) relative to the market capitalization of the index.  So, the stocks that make up the highest weight in the index are the ones that have already been bid up by the market to the point where they are worth more than the others.  By investing in a fund that mirrors one of these index, you’re piling into the stocks that already have reached celebrity status.  You don’t own tomorrow’s Amazon or Facebook, or enough of it to matter, because they are too small today to get much (or any) weight within the large ETFs.

For some companies with strong cash flows and well-established business models (think: Exxon Mobil, Wal-Mart, Boeing), high valuations can make sense.  But for every one of those, there is an overvalued dud.  Remember Enron, Eastman Kodak, Woolworth’s, Trans World Airlines, Pan Am, WorldCom, RCA, Compaq, or   At one time, each of these was a hot stock with a very high market capitalization, but now they are all confined to the history books.  Which of today’s high flyers will join that infamous list one day?  Apple?  Volkswagen?  BP?   All of the above?

The “illusion of diversification”.

It is easy to be lulled into a false sense of security by thinking you are diversified because you hold 20 or 30 of the biggest publicly traded companies in a sector instead of just one.  But, it’s typical for the largest 4 or 5 to comprise over half of the weight in a sector ETF.

What about holding all the sectors?  If you own many retailers, chemical companies, oil refiners, banks, wireless providers, technology firms, and mining companies, surely that is enough diversification?.  In 2008 and 2009, that didn’t work so well.

S&P 500 Index, from 2006 to 2009

S&P 500 Index, from 2006 to 2009


Correlations between different stocks and sectors always increase during times of financial stress – which are precisely the times when you need true diversification the most.

Another way of saying this is that when the markets are panicked, everything gets sold – the baby, the bathwater, the tub, the copper pipes in the bathroom, the house itself, and the land it rests on.  Imagine if you had just retired in 2007 with a “diversified portfolio” full of stocks.  By 2009, half your assets had vaporized.

True diversification requires owning multiple asset classes, including alternative assets, in proportions that are optimal for today’s investing environment.  I also encourage investors to consider using options to manage portfolio risk.  This will be a topic for future posts.


ETFs are more popular than ever, creating opportunity for active investors

Hedge funds are closing at an increasing pace.  Institutional money managers and individual investors are flocking to ETFs in record numbers.  Since gaining mainstream status in the 1990s, index funds have captured a larger share of overall stock assets nearly every year since 2000, according to CNN Money.  There are over 1,000 ETFs today, with new ones released every week.  They track a mind-boggling number of indexes, with tongue-twisting names like the “Dow Jones FEAS Titans 50 Equal Weighted Index” and the “Dow Jones Europe Developed Markets Select Real Estate Securities Index.”

This article, from Julia La Roche at Yahoo Finance, is a reminder of how dangerous this phenomenon can be for buy-and-hold index fund investors.  In it, independent researcher Steven Bregman warns of an “indexation vortex that’s distorted clearing prices in every type of asset in every corner of the globe.”  He emphasizes the systemic risk that ETFs pose, an argument that has become more mainstream lately as ETF “flash crashes” become a more common occurrence.  But I’d like to focus on what I feel is the critical point here – the tremendous opportunity the ETF boom provides to active investors.  That is, the “golden age of active management.”

Every dollar that moves OUT of an active fund (e.g. hedge fund or actively managed mutual fund) or an active strategy-based approach INTO a passive, indexing plan puts you and I one step closer to being one of the “first movers” I mentioned earlier.  It’s as if you own a home improvement store in your city, you’ve just watched Home Depot close its doors, and Lowe’s has announced a going-out-of-business sale.  Fewer investors identifying mispriced stocks leaves more money on the table for savvy active investors.

It’s a fantastic time to manage your own investments!


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