Jumpstart Your ETF Journey: Trading, Investment Strategies for Canadian Beginners

This comprehensive guide will introduce practices such as dollar-cost averaging, asset allocation, short selling, and hedging, with the aim of helping you more confidently trade and invest in ETFs.

Dollar-Cost Averaging: Steady Investing for Long-Term Success

One of the most popular and straightforward ETF investing strategies is dollar-cost averaging. This approach involves investing a fixed amount of money at regular intervals, regardless of market conditions, rather than investing a lump sum all at once.

Lump sum investing can expose investors to the risk of poor market timing if they invest right before a market downturn. On the other hand, dollar-cost averaging allows investors to spread their investment over time, potentially reducing the impact of market volatility.

Here's an example of dollar cost averaging. Suppose that John holds the majority of his portfolio in an ETF tracking the S&P 500 Index. Every month, John commits to investing $500 in that ETF in a consistent and scheduled manner. This is a form of dollar-cost averaging.

Here's another example. Suppose that Sue holds the majority of her portfolio in an ETF tracking the S&P/TSX 60 Index. Sue just received a windfall of $12,000 but is hesitant to invest it all at once in case the market crashes right after. To mitigate this risk, Sue decides to dollar-cost average it over a year by investing $1,000 every month.

To implement a dollar cost averaging strategy, first determine a fixed amount of money you are comfortable investing at regular intervals (e.g., weekly, monthly or quarterly). Next, choose one or more ETFs to invest in, and consistently invest your predetermined amount at each interval.

By sticking to a dollar-cost averaging strategy, you can avoid the emotional pitfalls of market timing or the stress of investing large sums of money at once. For more information, consider reading CIBC (TSX:CM) Investor's Edge guide to understanding dollar-cost averaging.

Asset Allocation: Building a Diversified ETF Portfolio

Asset allocation is a fundamental investment principle that involves spreading your investments across various asset classes, such as stocks, bonds, cash, and commodities. The goal of effective asset allocation is to reduce risk without impacting expected returns too much.

Asset allocation works because different assets have varying degrees of expected returns, sensitivities to market and economic conditions, and resilience and weaknesses to different sources of risk.

For example, stocks tend to do well under favorable economic conditions, while bonds have historically provided protection during recessions. Commodities can provide a hedge during periods of high inflation.

Moreover, these assets are not always perfectly correlated. That is, some zig while others zag. By combining them in various proportions in a portfolio and rebalancing periodically, investors can potentially reduce risk while still ensuring a decent return.

There is no one-size-fits-all asset allocation. The ultimate composition of your portfolio should depend on your risk tolerance, investment objectives, and time horizon considered holistically.

• Risk Tolerance: This is your willingness and ability to tolerate fluctuations in your portfolio's value. Investors with a higher risk tolerance may allocate a larger portion of their portfolio to riskier assets like equities, while those with a lower risk tolerance may prefer a more significant bond or cash allocation.
• Investment Time Horizon: Longer investment horizons typically allow for more aggressive asset allocations, as there is more time to recover from potential market downturns.
• Financial Goals: Your specific financial goals, such as saving for retirement, funding a child's education, or making a down payment for a home purchase may influence your asset allocation decisions.

For more information on how asset allocation works and how it benefits your portfolio, consider reading CIBC Wood Gundy's guide to understanding asset allocation.

Short Selling: The Approach to Follow During Market Downturns

The market goes up and down, but it doesn't mean that investors can only make returns when it goes up. By trading ETFs, investors can also take the other side of this bet. The most common way is via short selling, which allows investors to potentially profit from declining asset prices and market downturns.

In a nutshell, short selling involves borrowing shares of an ETF from a broker and selling it in the market, with the expectation that the price will decline. If the ETF's price falls, you can repurchase any shares sold short at a lower cost, return the borrowed shares to the broker, and pocket the difference as profit, less any interest and commission.

However, short selling is not without risks. If the share price of the ETF price rises, you will incur a loss when repurchasing the shares. If it continues to rise, your unrealized losses can be unlimited, as there is theoretically no cap as to how high an ETF's share price can go.

In addition, short selling requires the use of a margin account as you are borrowing securities. This often requires you to maintain a minimum account balance and pay interest on borrowed funds. If your unrealized losses hit a certain threshold that exceed your margin requirements, your broker may recall the borrowed ETF. This will force liquidation of your position at an inopportune time and lock in losses.

Due to the associated risks, short selling is typically more suitable for experienced investors with a thorough understanding of market dynamics and a higher risk tolerance. For more information on short selling, consider reading the CIBC Investor's Edge guide to short selling.

Hedging: Protecting Your ETF Investments

The term "hedging" refers to the practice of mitigating or offsetting investment risk by using other financial instruments. A great way to think about hedging is as portfolio insurance – you're paying for something that could help should certain bad scenarios play out.

The purpose of a hedge is to offset or reduce potential losses in your portfolio, thereby providing a safety net during market downturns or periods of heightened volatility. When it comes to hedging with ETFs, investors can employ two methods: inverse ETFs and options on ETFs.

Inverse ETFs are designed to provide returns that are the opposite of their benchmark index. For example, if the benchmark index declines by 2%, the inverse ETF should increase by 2% net of any fees. Vice-versa, if the benchmark index rises by 2%, the inverse ETF will decrease by 2% net of any fees. These ETFs use derivatives like swaps to provide the inverse exposure.

However, keep in mind that inverse ETFs can be pricey and are intended to be held for periods no longer than a day. Holding an inverse ETF long-term can lead to unpredictable returns due to the daily compounding of gains and losses. Some inverse ETFs also make use of leverage to provide up to two times (2x) the opposite return of an index. These ETFs can be even more volatile and unpredictable, so invest with caution.

On the other hand, options are derivatives that give the buyer the right, but not the obligation, to buy or sell an asset at a specified price before a specific date. A specific type of option commonly used to hedge are put options, which give the buyer the right, but not the obligation, to sell an underlying asset at a specified price ("strike price") within a specific time period ("expiration date"). For this, the buyer of the put option pays a premium.

Investors can buy put options on ETFs they hold as a way of hedging their investment. If the share price of the ETF falls below the strike price of the put option before the expiry date, investors can exercise the option, which allows them to sell the ETF shares to the seller of the option at the higher strike price. Alternatively, they can sell the put option for a profit higher than the premium they originally paid for it.

Options trading can be complex, and options pricing can be influenced by a myriad of factors. There is no guarantee that a put purchased will pay off, nor that it will successfully hedge against a market downturn. For more information, consider reading the CIBC Investor's Edge guide on options basics.

Key Takeaways: Putting It All Together

ETF trading and investment strategies like dollar-cost averaging, asset allocation, short selling, and hedging techniques are all highly useful tools to add to your investment repertoire. By understanding how they work and what the benefits and risks are, Canadian ETF investors are better equipped to manage their portfolios and achieve financial success.

Remember that these strategies are meant to serve as a foundation for your ETF investment journey. Continuously refining your approach, staying informed about market trends, and learning from your experiences will help you further optimize your portfolio, mitigate risks, and confidently navigate the ETF investment landscape.

This content was originally published by our partners at the Canadian ETF Marketplace.