A POTENT COMBO
“Trade what you see, not what you think,” and simplicity are core beliefs of Deron Wagner’s approach to trading exchange-traded funds as explained in Trading ETFs: Gaining an Edge with Technical Analysis. ETFs offer diversification, access to more markets and liquidity with lower trading commissions. Wagner asserts the only way to have a greater than 50-50 chance of predicting short- and intermediate-term trends is through sound technical analysis.
THE TOP-DOWN STRATEGY
The author advises first to determine the direction of the broad-market trend since as much as 90 percent of stocks, and hence ETFs, move in the same direction as the S&P 500, NASDAQ Composite and Dow Jones Industrial Average indexes. To clarify the broad market’s direction, use trendlines together with 20- and 50-day moving averages.
The active ingredient in this strategy is relative strength. Relative strength along with weakness of indexes and sectors can be found graphically or numerically. A visual trader would plot the percentage changes on charts to compare indexes. In contrast, a trader would tabulate the changes on a watch list for the numerical method. Wagner, himself, measures strength by the percentage change over a look-back period ranging from hours to days.
A sector’s relative strength—how its index is performing relative to its intraday range—is the last step to find the ETF with the most strength. Do not overlook ETFs with the most relative weakness as they make good short trades.
Only after determining the direction of the broad market’s trend and finding the index with the most or least relative strength is a specific ETF selected. For long positions, choose the ETF with the most relative strength within its group. Scan all ETF families that offer exchange-traded funds in a sector.
Because volume is a leading indicator, one should study volume to confirm an ETF’s relative strength or weakness. Analyze the broad market’s volume and an ETF’s daily volume relative to its five- or 50-day moving average.
BEYOND THE BASICS
Certain technical patterns and indicators supplement the top-down strategy. Head-and-shoulder patterns work well with ETFs. Wagner shows how to use the pattern and its inverse form for long and short trading.
The most profitable entries and exits key on support and resistance. An ETF’s 200-day moving average acts as a significant brick wall of support or resistance while revealing a position’s long-term bias. On the short-term side, a 10-day moving average acts as an important support and resistance level.
Wagner opens his trading diary to show his decision making from setup to exit when selecting 10 ETFs to buy long and 10 to sell short. Each trade exemplifies a strategy. Trading breakouts,...