iShares Russell 2000 (IWM) is an ETF that tracks the Russell 2000 Index (RUT). It is the most liquid...
How I Trade ETFs in a Volatile Market
08/18/2010 12:01 am EST
My methodology revolves around behavioral characteristics of the crowd and taking advantage of the extremes in sentiment, whether bullish or bearish.
In the case of ETF trading, I often work with 3x bull or bear ETF’s like BGZ, ERY, ERX, TZA, TNA, and so forth. Using a combination of Fibonacci retracements and Elliott Wave Theory, I look for high-probability setups and extreme overbought or oversold situations to trigger a trade recommendation. A most recent example with ETFs was a short position I took against the rising energy stock index, XLE. This index had become incredibly overbought in just a few weeks, and looking at prior topping indicators and Fibonacci trading day cycles, I felt it was a low-risk bet to short the rally. I bought ERY at $45.40 as the XLE headed over $56 and was becoming overbought. Within seven days, I had a 15%-plus gain by going against the crowd. I saw a 13 Fibonacci-day trading rally at extremes, so I used the XLE chart below to identify the timing to enter into ERY.
I use the same approach when it comes to trading individual stocks. I look for “waterfall decline” reversal patterns, which are somewhat proprietary for ATP and my methodology. This method reduces my entry risk because I am buying stocks that have already taken a recent short-term, multi-day or even multi-week hit as investors have exited the stock. Recent examples include buying DCTH, a former high flier that fell from $16 down to $5.80 when ATP advised purchase. Within days, the stock bottomed and ran to as high as $9 within a few weeks for a 50% move.
Another example is OREX, which took a hit in concert with VVUS several weeks ago. I felt the selloff was overdone and recommended the stock at $4.01 after it dropped from $6. The stock ran back to $5.30 within ten days for a 30%-plus gain.
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Trading in a volatile market means you need to be patient, discerning, and wait sometimes for an oversold or overbought condition before you act. Sometimes acting early can cause you to get spooked out of positions that end up being profitable, but only after you panic sell out at a loss. I use a “tranche buying” methodology, which tries to help with the emotional side of entering or exiting a trade. I recommend one-third or one-half positions at a time, even if you’re really confident in your entry point. This way, just in case you mistime the bottom of your target by one or two days, which often happens, you reserve some powder to add additional capital into the trade to work your way in over several days.
I also advise that traders enter into these tranches over 24 hours of trading time, perhaps buying three to four times into a position, especially on minor pullbacks. How many times have you bought into a trade entry at, say, $5.00 a share, and two days later, the position bottomed at $4.50, so you close it for a loss and then it runs to $6? Using a tranche buying methodology keeps your emotions in check, and you actually look for a bit further dip as a benefit, not a detriment to your trading.
I also adjust my stops as the stock or ETF moves after I have completed my entry. The main goal as a trader or investor is to book profits and limit losses when you are wrong. Since our ego is often our worst enemy, adjusting your stops as the trade moves in your favored direction keeps you from getting too giddy and letting a profit slip away. In addition, a reasonable stop prevents you from being overconfident and letting a small loss turn into a larger one.
Another recent trade example was buying into VITA, which was very oversold at the $1.76-$1.80 range. I took profits at $1.92-$1.97, with a nice and tidy 6%-10% gain over a seven- or eight-day holding period. The stock then fell hard just a few days later to $1.64. Not taking profits would have meant wiping out all of my hard work and watching paper profits turn into a “hoping-for-a-rebound” position.
In volatile markets, don’t get off your gameplan and try to keep your ego in check. Enter into your trades slowly no matter how confident you are, and over 24 -48 hours of trade time. Adjust your stops and prevent yourself from getting too greedy or giving away profits. Take your time, wait for setups, and take a break every now and again. Finally, remember that nobody needs to trade every day.
By David Banister of ActiveTradingPartners.com
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