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

ETFs: Analyze to profit

The top-down exchange-traded fund (ETF) strategy is designed to make consistent profits in both up and down markets. Based on a summary of this approach, most traders can get off the ground quickly. The top-down approach consists of three main steps, detailed in “Going with the flow” (below).

The first step is to determine the overall trend of the broad market: up, down or sideways. This is done through some basic trend analysis on charts of the major indexes, the time frames of which are dependent on whether a person is a daytrader, swing trader or longer-term position trader.

chart

The second step is to identify the industry sector indexes (including commodity and currency indexes) that are participating most strongly in the prevailing market trend. In a bull market, we would seek sector indexes showing the most relative strength to the major indexes. In a bear market, we would look for indexes with the most relative weakness.

Finally, the third step is to determine which specific ETF family is performing best within that particular sector index. For example, if semiconductors were a strong index, we would compare the relative performance of all semiconductor ETFs to see which one within the sector is performing the strongest.

Getting technical

The first step requires basic technical analysis that seeks to determine whether the S&P 500 or Nasdaq is in a dominant uptrend, downtrend or is range-bound. The time frame of the charts analyzed is dependent on the trader’s preferred holding period. If your trades are focused on, say, an average two- to five-week time horizon, you could use the daily time frame. Longer-term investors might use a weekly chart instead. Ultra short-term traders could use an intraday hourly chart time frame (or less).

Next, look for a series of at least two consecutive higher highs and higher lows (to basically define an uptrend) or two consecutive lower highs and lower lows (to determine a downtrend). This is just as easy as it sounds. A simple strategy is always best because it is most easily followed with discipline. We can see this analysis in “Going higher” (below), taken from a recent up trending period of the broad market. The point is marked where the S&P 500 confirms a new uptrend, after breaking out above a sideways range on its daily chart.

chart

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