TraderTalk: Don Miller On ETFs Vs. Futures

This is an edited transcript of Don Miller's live TraderTalk workshop on Thursday, August 15, 2002.

Brice Wightman: Today we are fortunate to have a gentleman who brings us a wealth of trading knowledge. He started out trading many of the same stocks we all did in the late '90s, but then made a transition to trading just the QQQs. Recently, he added the SPYs to his arsenal, with the same degree of success. It's my pleasure to introduce, all the way from Cape Cod, Don Miller...

Miller: Thanks Brice. Good afternoon all :-)  I thought I'd talk about one of the most asked questions I receive via email almost daily. Which is comparing trading the Exchange Traded Funds (ETFs) such as the QQQ and SPY to the E-Mini Futures. Many of you know I've traded the Qs for some time after migrating from stocks. I am also very familiar with trading the E-Minis. After all, all of the QQQ setups come from the Nasdaq E-Mini charts. And so the methods in the video and course are the same, regardless of which one a trader trades. And I do trade the E-Minis to understand the ETF trading.

My approach is the more one understands about the market, the better off one is. So to trade the Qs, one really should understand the dynamics of the futures market. Similarly, to trade the SPYs, one should understand the S&P futures counterpart. Anyway, there are distinct similarities and differences between the ETFs and E-Minis.

The similarity comes down to chart movement, setups, etc. QQQ = NQ ( Nasdaq EMini) and SPY = ES (S&P EMini). So since they both set up, move, etc., the same way (ETFs and futures). Which does one select as the vehicle of choice? There are basically four areas to consider:

1. Leverage
    
2. Liquidity/Order Entry
    
3. Commission differences, and
    
4. Tax treatment differences

So let's touch on each of these areas and make some comparisons. Before I do that, I'd like to state that there is no "right" answer in terms of which is "best" to trade. Trading is very personal and comfort, while an intangible, plays a big role in making a decision. Perhaps the greatest role. Anyway, let's look at Leverage. At the risk of stating the obvious, Futures allows one to trade a greater amount of capital vs. the ETFs.

Which has long attracted folks to the EMinis. My thoughts on leverage -- which many of you may know -- is I am not a strong advocate of it. As it's a double-edged sword, and the wrong edge for traders whose skills aren't refined or for pros going through a slump. And we all have slumps. And we all started at one time. Yet with the change in 2001 to allowing greater intraday leverage on the equity side, 4:1 equity (ETF) leverage is a lot.

So the Futures advantage has diminished a bit there, compared to the equities. But if you prefer leverage, the futures still get the edge there. OK, let's go to liquidity/order entry. Generally, the liquidity is better on the ETF side. Not always, and there will be times when the sizes on the futures will exceed that of the ETFs.

But let's walk through this. Keep in mind I stare at an Island ETF book for almost six hours a day and also often have a futures screen up. So we can make several comparisons and contrasts. Let's look at the Nasdaq side first.

QQQ vs. NQ

The liquidity on the Qs typically outweighs that of NQ. For a couple of reasons -- first, NQ is priced in 50 basis point increments. For example, we closed at 985.00. Next price is 985.50, then 986.00,, etc. And there's a queue (no pun intended) or line that you must stand in. You can't cut the 50 basis points. So if there's 50 NQ contracts on the ask as you choose to bail. And you put yourself in line and become #51, it has to tick all 50, before it gets to you.

There has to be sufficient demand to get your fill. Now of course, you could hit the bid and lose the 50 basis points and get out. But let's compare that to the Qs. The Qs are priced in penny increments. And some brokers will allow you to set your ECN price in tenths of a penny! For you QQQ or SPY traders, look at your Island execution records. And you'll see 24.529 or something like that.

So if the Qs are trading at 24.50, you can cut in at 24.49 or in some cases 24.499 and get yourself first in line. Also, the nature of an ETF as a tracking entity is such that. Many times the futures only need to tick one contract. And that will trigger thousands of ETF shares at the equivalent price!

Not always. Not all the time, as demand is still somewhat of an issue for trading the ETFs. But since the ETFs MUST, repeat MUST follow the futures in a 1:1 relationship pricewise otherwise an unsustainable arbitrage opportunity would exist. Your fill opportunity is likely often better on the ETF side. This is especially true in the Nasdaq market. Again, QQQ vs NQ.

Now on the S&P side, it's a bit different. ES as you may know is priced in 25 basis point increments: 930.75, 931.00, 931.25 etc. And the SPYs are priced in the 90s. So it's really a bit of a mixed bag there as far as which is easier to execute. Wider spreads allow you to split them on the SPY side, yet the liquidity on ES is far better than NQ (generally). You do have the same potential for one ES contract to tick thousands of SPYs. Yet ES has darn impressive volume ;-)

And this would likely only be an issue during illiquid market times. The liquidity on both the ETFs and EMinis is exploding. There seems to be an industry migration from the Qs to the SPYs to the EMinis. And I could talk for days about how the new futures players are causing some of the extreme intraday trends, but that's a topic for another day ;-)

Anyway, let's look at commissions: Issue #3. This will really depend on your trading style, broker, etc. There are many variables at play here. Oops, let me go back to the liquidity issue for one last point. One other benefit to the ETF liquidity is the larger pool of equity players (generally), although again this will fluctuate. Ma and Pa are more likely to be investing/trading the Qs than the futures, so there's often a larger pool to work with. But again, that's subject to change.

OK, commissions. Variables include: How frequent do you scale in and out, do you pay futures commissions per-contract or per-trade, does your ETF broker have large size fees, what re the ECN ETF fees, etc. Size-related charges aside, and assuming a discount per-contract broker, a small lot trader or one who pares in and out frequently will typically do better with the futures. As in you could scale into NQ 4 times and your commission might be 4 x say $5 or $20. Doesn't matter if you scale in or buy them all at once ... assuming per contract pricing again Same commission.

Compare that to the ETFs where the same trade sequence would often result in 4 x $15 or $60. Now I know that some brokers charge once if the trades are all done within X time period. That is another variable on the ETF side.
Size players typically do better on the ETF side. 10 contracts $5 = $50 on NQ using the same logic.

I trade 10k shares for an ECN assuming no size fee can actually be traded for $15 in some cases. I'm assuming $15 which obviously varies by broker, your volume, excludes ECN and SEC fees, etc. Now large players probably don't care mainly about commissions. But it's still part of the cost equation, especially if you trade frequently. I recently created an Excel spreadsheet that compares the two scenarios and factors in many of these variables. I'll talk to the TM folks so see what we can do there in terms of making it available.

OK, last issue: taxes. This is a large issue for some of us. Index Futures contracts per the IRS are taxed 60% using long term capital gains rates. Now I'm not a CPA, or Tax Accountant, but I am familiar with the rules. The disclaimer is to check with your accountant of course ;-). But IRS Pubilcation 550 (pages 37-38) addressed this. Because of the nature of futures contracts, which can't be easily related to a specific time period, there is a 60% default provision that goes to long term. Doesn't matter if you hold it for two seconds.

Now if you're a MTM trader, again check with your accountant (Mark to Market classification). In my state, this is a huge issue. For example, Massachusetts taxes short-term capital gains at a whopping 12%. That's not a typo unfortunately. It's a chunk. So other factors aside, the rate and impact on one's bottom line can be a strong issue.

As I said earlier, the choice should really come down to comfort, but these factors should be considered. For example, I still trade the Qs because I'm very very comfortable with them and their liquidity, which sometimes is more important to me than the tax issue. You will need to make similar choices. So there's again no right or wrong.

Question: The Qs don't have much intraday range these days. Do you still consider them a good trading vehicle? Do you think SPY is better because of its greater range?

Miller: Good question. Keep in mind that the Q range is tied in part to the lower price. So at the risk of stating the obvious, the same % move now will look smaller than when the Qs were in the 40s. One can and likely should compensate for the lower price by adjusting share size. Yet we've all noticed at times, especially when the S&P tanked a few weeks ago, that there were times the volatility on the SPY/ES was greater than the QQQ/NQ side. So I think the answer depends in part on current market rhythms. Are the Qs still tradable? You bet.

Question: Although the E-minis trade almost 24hrs/day -- outside the regular market hours the liquidity looks very thin and risky. Comments?

Miller: OK, a good question on the liquidity side. And I should have mentioned this earlier. The EMinis trade from 4:45pm ET until 4:15pm ET the following day via Globex. They only shut down for 30 minutes. The Qs on the other hand are typically tradable from 7am ET to 8pm ET. I say typically because that will depend on your broker. So liquidity in terms of time to trade go the the futures. Yet the market participation is usually pretty lame. So yes, there's added risk. Just as there would be in any thin, low volume market. Yet the setups and patterns are of course similar. Just a LOT fewer folks. So you still see pattern crosses, cups and handles, trends, reversals, etc.

Question: I notice on SPY that the Last Sale Price if far outside the bid and ask. What is going on there? Also, the spread can be quite large. Is that normal?

Miller:  OK. The ETFs , especially the SPYs are known for what I call out of market prints because you have traders jumping in and out on Island and other ECNs, sometimes in a panic when the market doesn't follow through, you'll often see prints outside the inside bid and ask. That's why in my course I stress to only watch futures charts if trading the ETFs. I discuss order entry tips in the course, which includes the ECN sweep entry which is often very appropriate and necessary to get your fill when you want to and which, yes, will result in an execution outside the inside bid/ask. How are we doing for time Brice?

Wightman: Perfect. I just want to say thanks, Don, and mention that Eddie Kwong has some excellent deals on your "How I Make A Living Trading The QQQs" video, and the "QQQ & SPY Trading School." If you've ever thought about these courses before, now's the time. The offer expires Sunday, August 18. Thanks again, Don, and have a nice evening.

Miller: Thanks Brice .. hope the info was helpful :-) Have a pleasant evening all :-) Good Night.