Pros and Cons of Trading ETFs

12/08/2009 12:01 am EST

Focus: ETFS

Linda Raschke

President, LBRGroup, Inc.

The following is an excerpt of an interview with Linda Bradford Raschke from chapter two of ETF Trading Strategies Revealed.

Vomund: Is it Worth Daytrading ETFs?

Raschke: In my opinion, no. There are far better vehicles for daytrading. Either futures or higher beta stocks are better. The problem is that few ETFs have the volume and liquidity for fast and effective execution, and the ones with sufficient volume tend to be the slower movers.

ETFs are so broad and encompassing that they can be classified into two groups. A small number of ETFs are heavily traded and very liquid, such as the Spyder (SPY) that tracks the S&P 500, but most aren’t liquid enough for active daytrading. Many global and sector ETFs might only trade 50,000 shares a day.

The vehicle you choose to use for daytrading depends on your execution platform, your commission structure, and your objectives. I know people who successfully trade the Spyder (SPY), but most professional daytraders will choose the E-mini S&P futures instead because of the greater leverage.

The advantage of ETFs is that they cover such a broad spectrum. They allow investors to easily buy equities from many countries or individual sectors. And because an ETF contains a basket of stocks, one bad apple is usually offset by the other stock holdings. When you trade a basket of stocks, you’ll do better trading a longer time frame as opposed to a shorter time frame. Longer time frame charts show smoother price movement and less noise.

Vomund: So professional daytraders typically aren’t interested in trading ETFs. How about the trading investor? By that I mean someone who doesn’t follow the market throughout the day, but places trades with a holding period of several days to a few weeks.

Raschke: The more volatility and liquidity an individual market has, the shorter the time period that you can trade and use for your analysis. With ETFs, I’d use daily and weekly charts exclusively and turn off the real-time charts. If you placed an order on many of the foreign market ETFs, you might as well execute the order on the open or the close because these ETFs don’t trade much throughout the day.

Still, whether you use intraday charts or weekly charts, you always go through the same process of determining if you should be a buyer or a seller, determining support and resistance, determining the trend, determining consolidation points, etc. The foreign ETFs were some of the best investment vehicles last year.

Vomund: What methods do you use to time your entry points?

Raschke: Because ETFs hold baskets of stocks and are more diversified than individual stocks, they respond very well to simple chart analysis. I believe that there are no more powerful tools than the techniques that have been written about in classic technical analysis literature. I trade the basic chart patterns like the triangle. I trade breakouts, and I trade pullbacks after breakouts.

This is simple stuff, but it is all that is needed to be successful, and it eliminates a lot of the noise in the market when the techniques are applied correctly. Watch the previous swing highs and swing lows as well as the length of the swings up and down when timing entries.

NEXT: Case Studies Featuring Real ETF Trades

|pagebreak|

Vomund: Can you give some examples?

Raschke: Sure. Because it has had lots of movement, let’s look at the weekly chart of iShares Japan Fund (EWJ) (Figure 2). It is easy to notice that during 2000-2003, all the major swings were greater to the downside than the upside. Notice the lower highs and lower lows.

chart
Click to Enlarge

Within this time period, there was a drop in 2001, followed by a reaction move to the upside (point 1). Since the trend is down, traders should short into this reaction. A second leg down ensued in 2001, followed by another reaction up. The reaction was also a classic ABC-type move (rallies to point A, falls to a higher low in point B, and rallies above point A to point C) with a classical momentum divergence on the way up (see trend line on momentum indicator). This is one of the best shorting signals that you can get.

The last leg down had a clear loss of momentum, as the drop was not as great as the second leg lower. As a result, a positive divergence formed in the momentum indicator. That is, the oscillator made higher lows.

Then in June/July 2003, there was a very sharp spike up. This was the first swing greater in the opposite direction than the previous downswing. As it was much greater than the previous swing high, the summer swing high showed that the market had changed its character. You now switch from shorting reactions to buying pullbacks.

Beginning in the summer of 2004, EWJ began to drift. After the breakout from the triangle, you can see at point 2 that momentum made new highs, confirming the breakout. An uptrend was in place, so traders should now buy the pullbacks.

Weekly charts display longer-term moves, and as they filter out a lot of the market noise, they tend to show smooth and consistent swings. They are very easy to read, but their analysis will not provide many trades. More active traders can perform the same style of analysis on daily charts.

Looking at the daily chart (Figure 3), EWJ drifted sideways for about a year before activity increased in August 2005. In the months preceding August, there was a classic contraction in volatility, demonstrated by the converging trend lines. Every good break away from a low volatility point will have either a gap or a large range increase with increasing volume. With EWJ, there was a large gap on August 10 with heavy volume. If you don’t see the start of the uptrend on the chart, you certainly will on the momentum indicator (point 1), where the oscillator far exceeded its previous high points. Daily chart traders can begin to trade the pullbacks after this new momentum high.

chart
Click to Enlarge

It is important to choose ahead of time what side of the market, long or short, you will play. That’s how you work most efficiently. In the case of the Japan fund, you look to short the reactions until mid-2003, and then you look to buy the pullbacks once the trend has changed. You don’t want to work both sides. Instead, work the side with the most potential gain.

NEXT: More Helpful Analysis Keys and ETF Trading Tips

|pagebreak|

Vomund: Taking advantage of pullbacks against the overall trend is an important part of your strategy. Is there a certain moving average that you like to see the security pull back to?

Raschke: Moving averages can be tools for your eye to spot pullbacks, but there isn’t an optimal moving average that works best. I use a 20-period exponential moving average as a default, though.

Vomund: At what point during a reaction against the overall trend should you enter a trade?

Raschke: That depends on how aggressive or conservative a trader you are. An aggressive trader might initiate a small-scale entry if he perceives a slowing of the reaction, whereas a conservative trader should wait until the market starts to turn back toward its trend. It also depends on the liquidity of the security. In a less liquid market, a trader will get a more advantageous price entering a long position when there are lots of sellers, and vice versa. In other words, you should try to enter before the security turns as long as you are still confident that you are trading in the direction of the higher time frame trend.

Vomund: Do you limit yourself to trading just the first two or three pullbacks, figuring that at that point, a true trend reversal is due?

Raschke: You never want to limit yourself in a strongly trending market. Look at crude oil or gold—there have been lots of pullbacks, but the trend is still higher. You should be careful late in the game because the security might be ripe for a bigger shakeout, but you try to differentiate whether it is a normal trading environment or if a really powerful force is at work.

It takes a lot of time to reverse a strong trend. There is usually an extended period of accumulation or distribution, so it would be extremely rare that a trend reverses on a dime without plenty of advance warning. Trend reversals are a process that often shows up in classic chart formations like head and shoulders or broadening formations.

Vomund: Let me give you another example to look at, the iShares Russell 2000 (IWM).

Raschke: This has actually become a better trading vehicle than the Nasdaq 100 (QQQQ). Let’s start with the weekly chart for IWM. Remember, weekly charts offer cleaner, prettier, and more symmetrical swings than charts with shorter time frames. Using the longer time frame, you get smoother data, less noise, and a clearer picture of the trend.

The weekly chart is in a solid uptrend where all of the upswings are greater than the downswings (Figure 4). There have been strong corrections, but the ETF remained in an uptrend. That’s because for an uptrend to reverse, the security must have a lower high, a lower low, and then turn down. Because there are swings in a long-term uptrending pattern, weekly chart traders should trade the periods when the momentum indicator is increasing.

chart
Click to Enlarge

You also have to be aware of what time frame you are trading on. Someone using a weekly chart will just trade long, while someone using a 15-minute chart, although the security is in a long-term uptrend, may go short. And IWM is one of the few ETFs that can be effectively daytraded.

Looking at its 15-minute chart, the trend reversal that occurred in early March was a great shorting spot. In Figure 5, at point 1, the security made a lower low. The momentum oscillator at point 2 was lower than previous swings, implying the start of a bearish move. Active traders can short the pullbacks. So a daytrader can short even though longer time frames show an uptrending pattern. You have to know your time frame. You can see that 15-minute charts have a lot more noise in the data and don’t have the same rhythmic swings that the weekly chart does.

chart
Click to Enlarge

NEXT: Article Concludes with Important Closing Ideas

|pagebreak|

Vomund: You’re right when you say you are using simple, classic technical analysis tools.

Raschke: I have to be honest with you; the stuff I do is so basic. However, this is what works for me. There will always be books covering new forms of technical analysis, but that doesn’t mean the simple, classical technical analysis techniques don’t work. They worked in the past, they work now, and they will work in the future.

It doesn’t matter if you are a short-term aggressive professional or a longer-term investor, success depends on simply understanding the basic swings. You’ve noticed I’m not using fancy indicators. It is more important to simply understand the significance of the patterns, whether the security is in an uptrend with higher highs or in a downtrend with lower lows.

That’s all I’m doing. I’m analyzing supply and demand shifts by the length of the swings, by whether momentum is increasing or decreasing, by whether there are higher highs or lower lows.

Vomund: Whether you use real-time, daily, or weekly charts, are there some common themes for managing a trade?

Raschke: Managing a trade means two things: Placing an initial stop and following an exit strategy. Here are the common themes. Back testing and modeling price behavior shows that the great majority of the time maximum profitability is achieved by playing for small wins as opposed to shooting for a large gain. Few patterns test out where one can play for a larger gain by using a trailing stop type of strategy. Instead, our work shows that you should at least be pulling up your stop to a break even once the trade begins to work, and then have a mechanism that forces you to take profits.

Our work shows that a combination of an initial fixed stop plus a time stop is ideal. I often employ an eight-bar time stop in conjunction with a fixed stop (i.e., using a ten-minute chart, you use an 80-minute time stop, using a daily chart you use an eight-day time stop, etc.). If a trade is not working in eight bars, then it can be exited. This is true regardless of what time frame you are using.

Finally, it is important to minimize the risk of having a large loss. You don’t ever want to take a large loss. Sometimes traders end up with a big loss because they were hoping for a big profit. The best traders first learn how to play good defense.

Vomund: What advice do you give to those who want to trade ETFs?

Raschke: Go to where the action is. Don’t pick a dead market that isn’t doing anything, hoping it will eventually break out. You have so many markets available to you that you should find choices with nice readable swings. Go to where the volatility is and where supply and demand imbalances exist. One last consideration with ETFs is relative strength work. The leaders continue to remain the leaders, while the dogs will tend to continue to underperform.

For your average readers, I would also recommend to never get discouraged at the overwhelming amount of noise that there is in the market. Classic technical analysis eliminates this noise. Simply pull up charts and examine the trend, and within the trend, the individual swings. You’ll see they are pretty predictable. Of course, it is always easier to see the swing patterns in hindsight, but with a little practice, you’ll identify them as they develop as well.

Vomund: Thank you for sharing your insights.

The preceeding was an excerpt of David's interview with Linda Bradford Raschke from chapter 2 of ETF Trading Strategies Revealed.

Related Articles on ETFS

Keyword Image
The Omen
12/07/2017 10:50 am EST

The probability of an equity market correction over the next few months is slim to none, so there co...