The exchange-traded fund (ETF) was introduced into the market in 1993 by State Street Global Advisors and developed by the American Stock Exchange. These financial instruments quickly have become one of the best kept secrets among high-performing traders in recent years.
The individual trader who uses ETFs for trading opportunities has access to a vast market of tradable securities. These include vehicles that reflect baskets of stocks, currencies, metals, commodities while avoiding the volatility of the individual underlying issues. While traders can achieve this risk avoidance through index futures and options, not everyone can access these vehicles or handle the imbedded leverage or contract rolls.
The avoidance of this volatility is most obvious in the case of individual stocks. For example, if one stock has an earnings disappointment, it is not uncommon for that stock to open 10 or more points lower at the beginning of the trading day. However, the performance of an entire sector will not be so negatively affected, and an index that includes that stock won’t experience as much of the shock. Traders who have positions in an ETF based on that index will enjoy a more resilient portfolio.
Of course, the benefits of index sector trading have been available prior to ETFs. Futures contracts, mutual funds and options are a few examples of index-based financial instruments. However, while all of these vehicles have a place for traders along the dual continua of experience and risk tolerance, ETFs deliver for individual traders. For most of us, ETFs provide levels of flexibility, accessibility and liquidity that have never existed before.
This lack of volatility helps indexes, and the ETFs based on them, trend better and have smoother performance in price action. This makes them attractive to traders who desire consistent performance while minimizing risk. Here, we’ll look at some trading tools that work well in identifying profitable market moves.
ETFs, TRENDS & TRADING
Mark Boucher, hedge fund manager and author of “The Hedge Fund Edge,” once wrote that “trends are to traders and investors what oil is to oil wildcatters.”
Price trends, by definition, will stay in place for some time. Generally, during that time, they experience extended directional moves that are expansions in price (in an uptrend). Dips or pullbacks occur, but are followed by a resumption of the initial directional move.
Those on the sidelines who observe these trends taking place use dips and pullbacks to initiate new trade positions that, in turn, become a type of self-fulfilling prophecy in that the trend tends to resume from these points. Price then resumes its move in the direction of the trend almost as if it were “magnetized” to do so because of the sheer number of traders and investors buying into these temporary declines or rallies.
By observing price action and implementing a sound method of entries and exits, you can exploit trends in price action across a universe of available ETFs.
THE TOOLS
One of the more common methods of entering and exiting trend trades is using a combination of leading and lagging indicators.
Williams %R is a leading indicator that compares each closing price to the recent range indicating whether bulls can close the price near the top of the range, or bears can close the market at the bottom of the price. “Williams” refers to trader Larry Williams, who popularized the tool.
The 50-day simple moving average (SMA) is the average close of price for the last 50 trading days and, as a result it is a bit slow. This is why it is classified as a lagging indicator. However, if it is trending then it signals that a trade setup is possible for entry.
MACD, which stands for moving average convergence-divergence, shows the difference between a fast and slow exponential moving average (EMA) of closing prices. Because it is based on moving averages, MACD is inherently a lagging indicator.
ETF LONG TREND SETUP
The 50-day SMA is used as a filter to identify periods that are ripe for long positions. For a bullish setup, price must be trading above the 50-day SMA.
The Williams %R is a leading indicator that is used to signal a long entry into the trend when price pulls back, resulting in the indicator dipping under the -80 level. You will then enter on the close of the price bar after the Williams %R signals momentum has resumed into the dominant trend by triggering the entry when the indicator rises back up through the -80 level.
The MACD is a lagging indicator and is used as a confirmation of the entry signaled by Williams %R. It is not essential, but acts as a secondary signal to confirm the trade.
The long setup is as follows:
1) The 50-day SMA must be pointing upward or traveling in an upward trend.
2) Price action must be trading above the 50-day SMA.
3) Williams %R must dip below the -80 mark to set up a possible signal.
4) Entry is triggered when Williams %R rises up through the -80 level.
5) Set your price stop under the price bar immediately preceding the entry bar at the lowest intraday pivot low.
6) Entry confirmation is signaled when the fast EMA crosses up through the slow EMA, as indicated by MACD.
7) Exit the trade when it dips back under the -80 level.
ETFs allow you to trade securities on a global level, and these markets provide a good example of this trading strategy.
“One observation I have been watching lately is the relationship between oil and gold and the country ETFs of Australia (EWA), Brazil (EWZ) and Russia (RSX),” explains Rick Pendergraft, editor of the Stark Report. “These three particular ETFs seem to move independently (to some degree) from other indexes, because their economies are tied so closely to raw materials.”
A look at iShares MSCI Brazil Index (EWZ), which seeks to provide investment results that correspond generally to the price and yield performance of publicly traded securities in the Brazilian market, as measured by the MSCI Brazil index, shows some interesting ETF setups (see “Long on Brazil”).
On Sept. 3, 2009, EWZ signals an entry at the close at $58.21 as the Williams %R comes back up through the -80 level, while setting your stop under the previous day’s intraday low. Seven days later, the MACD confirms the entry and the trade is managed for the next seven weeks as it makes its way higher. On Oct. 27, EWZ signals an exit at $71.48 as the Williams %R dips below the -80 level, showing a shift in momentum to the downside. The trade is exited with a 13.27 point gain which comes to almost a 23% gain in seven weeks.
Market Vectors Russia ETF (RSX), which seeks to replicate as closely as possible, before fees and expenses, the price and yield performance of the Russia Index, has offered some compelling ETF Long Trend setups (see “Russian opportunity”).
An entry was triggered by the Williams %R indicator on Aug. 19, 2009, at the close of the day at $22.40. On entry, the trader would immediately set a stop-loss under the day’s intraday low, as it had the lowest pivot point. A few weeks later, the MACD confirmed the entry when its fast EMA clearly broke higher over the slower EMA. RSX moved higher over the next several weeks before a sharp price break revealed momentum was shifting and resulted in the Williams %R going below the -80 level. The trade was exited on Oct. 28 at $27.59 for a 5.19-point gain and a return of 23% in just under three months.
Leveraged ETFs also work well with this strategy. These vehicles, generally termed “ultra” or “double” ETFs by the companies that issue them, use derivatives to double the returns — and losses — in the underlying market. PowerShares DB Gold Double Long ETN (DGP) seeks to replicate, net of expenses, twice the daily performance of the Deutsche Bank Liquid Commodity Index. Optimum Yield Gold Excess Return also offered several solid setups using the ETF Long Trend Method (see “Doubling up”).
DGP had been stuck in a trading range for the last seven months prior to breaking out on Sept. 3, 2009, which provided an ETF long trend setup on Sept. 29. That day, Williams %R triggered an entry as it came back up through the -80 level for an entry price of $22.31 where you would also set your stop-loss at the previous day’s intraday low. DGP inched higher with the MACD giving secondary confirmation on Oct. 6, 2009, but dipped down signaling an exit on Oct. 26 at $24.36. This first trade yielded a 2.05-point gain for a return of 9% in a little less than a month.
DGP quickly offered another setup three days later when Williams %R triggered another entry on Oct. 29, 2009, for an entry price at $24.72 where you would also set your stop loss at the previous day’s intraday low. A week later, on Nov. 5, the MACD confirmed the entry and price headed upward for the next several weeks. On Dec. 7, DGP’s price broke lower, shifting momentum to the downside and signaling an exit as the Williams %R indicator dipped below the -80 level. The trade was exited at $29.50 for a 4.78-point gain and a return of 19% in about five weeks.
VAST TRADE SELECTION
This method will not catch every bottom or exit at the highest high of every price top, but it will help you profit from the meaty middle of the trend. With a vast selection of ETFs to choose from you likely will have more actionable trades than your account can exploit.
Spend time mastering the steps and scanning the ETF market for new opportunities. You will begin to capture the strongest part of a given ETF’s trend, while minimizing your risk to both volatility and loss by using ETFs as a core component to your
trading objectives.
Billy Williams is a 20-year veteran trader specializing in momentum trading in both stocks and options. Read his market commentary at www.StockOptionSystem.com
