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.
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.
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.
The second step in the top-down strategy is to determine which indexes are showing the most relative strength or weakness to the broad market. There are two basic ways to accomplish this. The first way, which is probably easiest for traders just starting out with this strategy, is to compose a series of percentage-change charts, each of which compares the relative value of a particular index to the benchmark S&P 500 index. With this type of chart, we are not interested in actual prices; rather, we only want to see how an index has performed relative to the broad market. “Around the world” (below) shows a view of numerous sector indexes along with their relative performance to the S&P 500. These charts show relative price comparisons over the past 10 days.
Just a quick glance at this screenshot shows that gold, Treasury bonds, and the U.S. dollar (each highlighted with a pink rectangle) are currently exhibiting the most relative strength compared to the S&P 500. Conversely, highlighted with a blue triangle, both the oil service index and solar energy index show the most relative weakness. The former indexes may be potential buy candidates on a pullback, while the latter may be potential short sale candidates when the indexes bounce into resistance.
The other way of finding relative strength or weakness among various sector indexes is by using a quote watch list that includes numerous indexes, sorted by their relative performance to the S&P 500. This is a better method for traders who are good with numbers, after they have gotten the gist of the method above.
Once the strongest index has been identified (for going long) or weakest index (for selling short), drill down to the third step of the top-down strategy to see which specific ETF family associated with the index is showing the most relative strength or weakness to its corresponding index. Depending on the popularity of the index, there could be as little as just one ETF associated with the index, or there might be as many as 10 or more ETFs. To do so, we again employ percentage-change charts to overlay various ETF ticker symbols against each other.
If, for example, we determine the Biotech index ($BTK) is showing the most relative strength, then overlay the tickers of the main ETFs in that sector. “Finding the trade” (below) compares the relative performances of several different ETFs in the biotech sector.
Using the percentage-change chart to compare relative price performance of various ETFs within a particular index, it only takes a quick glance to determine which individual ETF is showing the most leadership (relative strength) to the actual index during any time interval of analysis. On the chart, First Trust Biotech (FBT) is slightly outperforming the actual $BTK Index. Conversely, the Biotech HOLDR (BBH) is the biggest laggard, registering only half the gain of the $BTK. Although both FBT and BBH are biotech ETFs, there was a huge difference in terms of relative price performance. Without using this type of chart to spot the most relative strength, you could easily make the mistake of buying the laggard. Conversely, if trying to determine relative weakness, it’s equally imperative to make sure you are selling short the weakest ETF within the weakest sector index.
Because there are more than 700 ETFs in the U.S. market, it’s easy to be overwhelmed when it comes time to decide on the specific issue to trade. The Morpheus ETF Roundup, a free download, is a compilation of the main ETFs by sector and sub-sector, simplifying the process of zeroing in on the most relevant ETFs for relative price comparisons (download Futures 2010 ETF Guide).
When scanning for potential plays, first filter out any ETFs with an average daily volume of less than 100,000 shares. Although ETFs are synthetic instruments, and liquidity is therefore not a direct concern, lightly-traded ETFs frequently have large bid-ask spreads. Furthermore, there is usually a suitable, less thinly-traded ETF with a similar portfolio composition.
Beyond the average daily volume requirement, simply choose the ETF with the most relative strength/weakness or chart pattern, rather than subjectively deciding which ETF group you prefer. Nevertheless, it’s important to realize commodity, leveraged and inverse ETFs are not created equally. For example, there are several different ETFs designed to track the price of the crude oil futures contracts, but some track more closely to the underlying commodity than others.
It’s a similar situation with leveraged and inverse short ETFs. Because these types of ETFs rely on a daily portfolio rebalancing of derivatives to arrive at their share price, they will rarely track exactly in sync with the underlying index they’re designed to follow, especially over the longer term. As with the commodity ETFs, some ETF families track more closely to the index than others. As mentioned earlier, a percentage-change chart that overlays the various ETFs of a particular sector with the index they’re designed to track is the quickest and easiest way to determine which ETF is the best to choose.
This article covered the basic steps to get one started with sector trading of ETFs, based on a relative strength top-down technique. A future article will demonstrate a preferred technique for determining the most ideal entry and exit points after the proper ETF is selected.
Online Extra: Morpheus ETF Roundup and ETF Guide
Deron Wagner manages the Morpheus Capital hedge fund and is the author of “Trading ETFs: Gaining An Edge With Technical Analysis.” He also edits the Wagner Daily newsletter. Contact him via www.morpheustrading.com.