Trading ETFs: Getting an Edge with Technical Analysis

11/03/2008 10:42 am EST

Focus: ETFS

Deron Wagner

Founder and Head Portfolio Manager, Morpheus Trading Group

Trading ETFs

Unless you have been living in a cave for the past few years (or have no interest in financial matters), you are probably aware of the explosion in the number and variety of Exchange Traded Funds (ETFs). Most of the books I have encountered on the topic simply discuss the tremendous increase in their popularity and make a case for why they might be preferable to mutual funds. It was thus a pleasure to read Deron Wagner's new book, Trading ETFs,which describes in detail the methods that one can apply to either trade or invest in ETFs.

The approach is very analytical and points out some interesting perspectives that I am confident many ETF traders have not considered. The book is divided into four sections with the first concentrating on the discussion of the major ETFs and ETF families; this includes a review on the relatively new actively managed, currency, and commodity ETFs. The second section of the book I found particularly strong as it explains Deron's top-down approach, which is explained in detail over the next four chapters. This includes determining the market's broad direction; finding the individual index that has the best relative strength; finding the individual ETF with the most relative strength (or weakness) relative to the index; selecting the ETF; and managing the position from the entry to the exit.

I found Deron's use of relative strength (not to be confused with Welles Wilder's Relative Strength Index) especially interesting. This is a technique that many of us have used in sector analysis, but Deron takes it a step further by applying it to the vast number of ETFs. He advocates using either percentage change charts or tabular data to find those sectors or indices that are doing better or worse than a major average such as the S&P 500 or Nasdaq.  His inclusion of relative weakness is something I have not often seen when developing trading strategies and, with the recent introduction of the single short and double short ETFs, is especially appropriate.  He finds this particularly useful in sideways markets where long positions can be taken in the strongest ETFs and short positions in the weakest ones. 

As an active trader, Deron has some insight than many of us do not and that is illustrated in chapter five when he advises you to know your ETFs.  By this, he means to understand what stocks are in a specific ETF and in what percentages. He points out, for example, that just because you determine the AMEX Biotech is performing better than the general market, you should not assume that all biotech ETFs should do equally well. The charts he provides are easy to follow, well-annotated, and demonstrate this point. This is why he recommends doing relative performance analysis of all the relevant ETFs to the underlying indices in order to select the best one. The disparities are often striking and are caused by not only the number of issues in the ETF but also their weighting. For example, one popular semiconductor ETF has over 34% in just two semiconductor companies. The composition of any ETF, of course, can be found on the Web site of the fund family. The second section of the book concludes with Deron's views on technical analysis, moving averages, chart patterns, and Fibonacci analysis. The treatment of this is generally spot-on, though I would question some formations that he identifies as the head and shoulder tops since some were formed within longer-term downtrends.  On the other hand he places a great deal of emphasis on the importance of volume to which I heartily agree.

The third section is aptly named "Timing Your Entries and Exits", which does an excellent job explaining his techniques for entering a trade, dealing with opening gaps as well as exiting both winning and losing trades. He emphasizes to the reader the necessity of proper risk management and also covers his view on trailing stops along with his tips on exiting positions intra-day. The final chapter includes some closing thoughts about a wide range of subjects including: not trading as a viable strategy, choppy markets, and the importance of risk versus reward.

In this short review it is difficult to do Deron's book justice, but this is often the case with the good trading books. There are many things that identify this as a book by a real trader. One was the review towards the end of the book of ten of his long trades and ten of his short trades. Though I have found similar sections in other books his review is consistent with that of a real trader in that his examples feature realistic profits and losses. This is in stark contrast to those authors whose winning trades show unattainable gains of 250-1500%. If you have considered managing you IRA using ETFs, this is the book for you, and if you are considering trading ETFs, start here.