Experienced investors working with their broker or other investment professional may also use
ETFs
to manage portfolio
risk.
For example, you might buy or sell options on certain ETFs if you expect the market to move in a certain direction within the near future. You might also consider pairs trading, or using ETFs to avoid a wash sale.
Pairs trading
With pairs trading, you seek to exploit the similarities and differences between ETFs and
stocks.
Here's how it works: Suppose your research tells you that ABC company has poor growth prospects but is in a sector that appears to be peforming very strongly. One way to capitalize on the difference between the performance of ABC stock and its entire sector is to short the stock and buy the
sector ETF.
Or, if the circumstances are reversed — the sector looks weak but ABC company is growing quickly — you can short the ETF and buy the stock. It's important to remember, however, that this strategy comes with obvious risks. If both the stock and the sector ETF produce results different from what you anticipated, your losses can be compounded.
Avoiding a wash sale
As part of a tax planning strategy, you may sell investments that have lost value during the year and use that loss to offset taxable
capital gains
on other investments. But it's crucial to the strategy's success to avoid what's known as a wash sale. That occurs if you sell an investment that has lost value, realize that loss to offset other gains, but then rebuy what securities law describes as a "substantially identical" investment within 30 days.
To avoid a wash sale, you might sell an investment that has lost value to offset other gains, and then buy an ETF that is similar to the investment you sold, but not "substantially identical" to it. After 30 days, you may buy back your original investment and then decide whether to hold or sell the ETF.
