For decades, market pros have successfully used chart patterns and other technical setups to trade stocks for profits. If you trade stocks off price patterns, you can use those same winning tactics trading exchange-traded funds.
Exchange-traded funds, or ETFs, have been around since ^SPY^, or “Spiders,” began trading on the American Stock Exchange in January 1993.
Because ETFs track indexes and other baskets of stocks, many of them trend like industrial sectors or the broad market. That is of special importance to traders and active investors. In other words, once they launch on a fresh direction, especially after a basing or consolidation, they tend to persist in that direction.
Stocks trend as well. But the fate of an individual stocks rides on the fortunes of its underlying company. The trader assumes a much greater risk that some unforeseen news (or problem or development) affecting the underlying company strikes out of the blue and reverses a favorable trend while its industry group continues on course.
In this regard, exchange-traded funds act like sector and index mutual funds. Their fates are shaped by the bigger, more resolute forces ruling the fates of industries and markets, rather than the more fickle fortunes of some companies.
But for the chartist, Spiders and other ETFs have a bit of an advantage over mutual funds — in a word, liquidity. Because ETFs trade freely on exchanges, you can buy, sell or short them just like a stock, any time of day, at the market price.
So when an ETF hits a double-bottom, 1-2-3-4 pullback or cup-with-handle pattern or any other technical signal used to trade stocks, you can often jump in and trade that fund in the same way.
Make sure, though, that the same trading behavior that makes stocks amenable to your favorite chart patterns holds true for the exchange-traded funds that you may choose to trade.
For instance, if volume plays a key role in your chart patterns, you should stick with highly liquid exchanged-traded funds. Thinly traded funds, just like thinly traded stocks, can send deceptive volume signals because a few big trades can easily to drive the day’s trading level well above the norm for that security.
Many of the WEBS country shares fall into that category. Their unreliable volume results in lots of gaps at the open, making short-term trading highly risk. However, WEBS do trend nicely, making some of them, notably the Japan shares
^EWJ^, good vehicles for intermediate-term trading.
Let’s say you trade off cup-with-handle or 1-2-3-4 patterns. Remember that these formations work best with high relative strength stocks. Avoid applying them to laggard exchange-traded funds just as you would ignore poor-performing stocks. Use TradingMarkets.com’s daily listings of top-performing ETFs to find candidates for this pattern, or generate your own lists using the FundScanner.
Take the 1-2-3-4 pattern, which was developed by short-term trader Jeff Cooper in collaboration with Larry Connors.
Basically, you find a stock or ETF in a powerful uptrend. Wait for the stock to make a three-day pullback, preferably following a short-term high. In the ideal setup, the target security makes a short-term high, then three consecutive lower lows, or a combination of lower lows and inside days. (Inside days are days for which the high is less than or equal to the prior session high and the low is greater than or equal to the prior session low). Buy on Day 4 if the security breaks 1/16 above the high of Day 3. Set a GTC (good-till-cancelled) stop order near the Day 3 low to protect against losses if the pattern fails.
The ^BBH^ exhibited three 1-2-3-4 patterns over little more than a month. The Biotech HOLDR made three lower lows on Jan. 3, 4 and 5 with a good close on the 5th, then triggered on Jan. 6. The fund made another 1-2-3-4 pullback on Jan. 11-14, and a third example of the pattern on Feb. 2-14.
For another example, check out the ^HHH^, which produced a 1-2-3-4 pullback culminating in an entry on Dec. 2.
Perhaps you use follow-through days to identify the end of bear markets or intermediate-term corrections and the onset of rallies and bull markets. William O’Neil, founder of Investor’s Business Daily, describes follow-through days in his classic, How to Make Money in Stocks, and 24 Essential Lessons for Investment Success.
Let’s say stocks have suffered a correction or bear market. Then the market rallies on one or more of the major stock indexes. This could mark the debut of a new uptrend, or it could be a misleading fluke, luring in premature bulls before sinking lower.
The follow-through day gives you a good chance of discriminating between a true rally and a bear trap. If the rally has staying power, four to seven days into the rally, the index or indexes that reversed to the upside should post a one-day gain of 1% or more on an increase in trading activity over the previous trading day. Valid follow-through days can occur later, but they tend to signal weaker rallies the further out they occur from the initial rally day.
Most traders use this signal to increase their exposure to individual stocks, which they buy as high relative strength issues break out of cup-with-handle bases and other bullish patterns. But since the follow-through day gives you a positive signal about the market, you can use index ETFs as well. For example, let’s say the Nasdaq Composite has been leading the market and follows through. You can buy the Cubes
^QQQ^ near the end of the session. If the S&P 500 is the better performer, you can buy Spiders
^SPY^ if the S&P follows through.
* Holding Company Depositary Receipts are a subset of exchange-traded funds that enable investors and traders to buy a fixed basket of stocks in a specific sector. HOLDRs differ from ETFs which track stock indexes and as a result reflect the changing composition of those indexes. Index-based ETFs include the Spiders and the Cubes, which track the S&P 500 and Nasdaq 100, respectively.