How to choose the right financial product to trade or invest in

There are 3 main components to trading:

  1. Buy and sell signals
  2. Risk management (stop loss, position size, etc).
  3. Financial products

Every trade is accompanied by a financial product: it’s how you EXPRESS that trade idea. For example, let’s assume your “idea” is that you’re bullish on the U.S. stock market. How do you express this trade? You can:

  1. Buy 10 different individual stocks.
  2. Buy $SPY (the 1x ETF for the S&P 500).
  3. Buy UPRO (the 3x leveraged ETF for the S&P 500).
  4. Buy $ES (S&P 500 futures).
  5. Buy options for $SPY

How payouts work for different financial products

Stocks and ETFs payout in a very simple way. Assuming that you didn’t buy on margin, you will make money if the price that you sell it at is higher than the price that you bought it at.
Futures have a more complicated payout. Assuming that you set aside enough cash for margin and didn’t face a margin call, your payout per contract = (difference between the price that you sell it at vs. the price that you bought it at) * the multiplier.
The multiplier is essentially the leverage in a futures contract. It multiplies all of the futures contract’s gains and losses.
Options payout in a very simple way. Combine the options’ “strike price” with its premium. Your profit =  (the price you sell it at) – (the strike price + the premium)
Options traders also need to keep in mind the options expiration date. If the market’s price is less than the “strike price” on the options expiration date, the options will expire worthless.
Different financial products use different levels of leverage.

  1. Individual stock traders don’t use leverage. 1x ETF traders don’t use leverage either.
  2. Leveraged ETF traders use a little bit of leverage (usually 2x or 3x).
  3. Futures traders use more leverage (usually 10-30x leverage).
  4. Options traders use an insane amount of leverage (e.g. a 2% decline in the market can make the options worthless).

Here’s how to decide which financial product you should trade.

Consider your skill level

Different financial products have different levels of difficulty. The complexity of various financial products depends on their specific characteristics.
New traders should stick to trading financial products that are easier to understand.
The general order is:

  1. Index and sector ETFs are the easiest to trade.
  2. Individual stocks are the second easiest to trade.
  3. Options are the third easiest to trade.
  4. Futures are the hardest financial products to trade.

Individual stocks and ETFs are very easy to understand. You make money if the price rises above your BUY price. You lose money if the price falls below your BUY price.
Options are somewhat difficult to understand. There are “in the money” and “out of the money” options. There are also many exotic options and exotic options strategies that are difficult to understand, such as the butterfly spread.
Moreover, there are many ways to setup a more asymmetric and profitable options trade using options mispricing tricks.
Futures are easy to understand but are insanely hard to trade. This is because it’s extremely difficult to consistently get the margin right.
Unlike stock and ETF investors, futures traders can lose more than 100% of their money. This is because futures traders need to set aside cash in the event of a margin call. Margin calls can happen at the worst time possible – just before your position turns out to be right.
For example, let’s assume that you are long $ES right now at 2000. You have enough cash set aside for $ES to fall to 1900. What if $ES falls to 1890 and then soars to 2400? You will be margin called at 1890, only to watch the market take off later like a rocket. A big profit just turned into a loss.
Futures do not allow traders to hold their positions until they are right.

Consider what you can stomache

Every trader and investor has a different tolerance for risk. Traders with lower risk tolerances should stick to individual stocks and ETFs because these markets have lower volatility. Traders with high risk tolerances should trade futures and options because these financial products offer higher volatility.

Consider compounding or erosion

I’d like to mention something about leveraged ETFs because this is what I trade.
Different market stages are more suitable for different kinds of financial products.

  1. Markets that trend strongly are suitable for highly leveraged ETFs (e.g. 3x leveraged ETF) because the ETF compounds on itself. For example, if the underlying market goes up by 1%, the 3x leveraged ETF will go up by more than 3%. This is compounding.
  2. Markets that are choppy are suitable for low-leverage ETFs (e.g. 2x or no leverage ETFs) because the ETF faces erosion. For example, if the underlying market goes up by 1%, the 3x leveraged ETF will go up by less than 3%. This is erosion.

Read this post about ETF erosion if you haven’t already.

Don’t trade too many financial products at the same time

Some traders like to trade multiple financial products at the same time. This is generally not a good idea.
It takes time to get used to the individual characteristics of different financial products (e.g. leveraged ETFs have erosion and compounding, but futures contracts don’t). We all have a limited amount of time each day.
Spreading yourself thin across multiple financial products means that you will become out of touch with every individual financial product’s characteristic. The best traders specialize in one or two products and understand that product from front to back. The understand all of the tricks of their financial product.

2 comments add yours

  1. Hi Troy – Are you still long UPRO? And if so, what about the erosion effects during this pullback/choppiness from the end of January?

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