From the March 01, 2010 issue of Futures Magazine • Subscribe!

ETF trading methods: A guide

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.

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