ETF Trading Tactics, Part 1: Identify ETF Turns Using Moving Average Crossovers
Exchange-traded
funds make an ideal weapon for exploiting market turns. Just
buy or short the tradable fund that tracks your chosen market or sector index.
In this lesson, I’ll teach you
the moving average crossover. Combined with
chart analysis, this indicator can serve as an effective
confirmation signal telling you when a market may have bottomed and reversed to the upside.
Some of you may be new to exchange-traded
funds. So let me digress for a minute before jumping into the
crossover.
Exchange-traded funds offer the
diversification of index mutual funds by spreading your dollar among
the stocks of many different companies. Some ETFs track indexes, others key in on
baskets of stocks that represent narrow industries.
Unlike mutual funds, the ETFs trade on
exchanges (just about all of them presently being listed on the American Stock
Exchange). These “tradable
funds” are quoted just like stocks, their bid and
ask prices adjusting throughout the day, in response to supply and demand. This
allows you to take advantage of moves and signals intraday.
Traditional mutual funds price only
once a day. After each market close, the fund houses calculate each fund’s Net Asset Value in
light of the closing prices of their component shares. This precludes mutual
funds from becoming trading vehicles, for most purposes.
For more information on these
securities, click on the Funds tab near the top of this page. Also read
my tutorial
on exchange-traded funds.
Crossovers: 10-day
and 30-day moving averages
A moving average crossover occurs when a faster (shorter)
moving average traverses a slower (longer) moving average. This can alert you to an
important change in trend. I find that simple 10- and 30-day moving averages
work well for intermediate-term trading.
However, the moving-average crossover does not constitute a complete signaling system by itself. Used
this way, you’ll enter many trades only to
get stopped out, eroding the returns of your positive trades to a much higher
degree than necessary.
You should use the crossover with other
evidence — namely price breakouts and
volume — to help confirm a significant trend change.
I regard volume as especially
important with crossovers. The action of any moving average, of
course, is affected by price. So a price breakout, while bullish, so some degree
will be reflected in the stock’s moving averages. Volume, however, constitutes
an independent variable.
Let me show you
an example.
The following chart shows the Nasdaq 100 Tracking Stock
(
QQQ |
Quote |
Chart |
News |
PowerRating) from September to November 1999. The Cubes, as they
are popularly called, are exchange-traded fund shares created to correlate
tightly with the Nasdaq 100
Index
(
$NDX.X |
Quote |
Chart |
News |
PowerRating). This index consists of the 100 biggest non-financial Nasdaq stocks by market capitalization.
As you can see, the fund’s 10-day
moving average, in red, crossed above the 30-day MA, in blue, on Oct. 11, 1999.
This coincided with the Cubes making a new high. New highs tend to be bullish.
But notice how volume dried up at the same time.
That tells me that the
market wasn’t quite ready to believe that the new high spelled a fresh advance.
The rally promptly stalled, the Cubes
headed lower, and the 10-day bearishly undercut the 30-day.
Then on Oct. 28-29, the market rallied
again. On Oct. 29, volume surged, a sign that institutional money was piling
back in. Bingo!
The same day, the Cubes not only made a fresh new high, they gapped
up to the record level, more evidence of conviction.
Meanwhile, the 10-day moving average crossed above the 30-day MA,
portending a trend change. It was all there: new high, strong volume and
crossover, plus the add icing of a gap-up price move.
That’s about as clear a buy signal as
you’re likely to get! The Nasdaq 100 and its tracking stock had just broken out of a
sideways trading range into a new uptrend.
Here’s a slightly closer look at the same series of events.
A Resilient Trend
Once you use a short average crossover
to lead a trend, you can also use it to test the same trend. In this case, once
the 10-day rose above the 30-day, the shorter average continued to lead the
longer one through the peak in the Nasdaq 100 on March 24.
When the 10-day finally rolled beneath
the 30-day on April 7, the bear market had begun for the Cubes, which
peaked at 120 1/2 on March 24.
Now obviously, I would want to get out earlier than April
7. But don’t expect to call market tops right at
the peak. The key is to get out with your profit intact. Don’t beat yourself up
if you escaped a bit early or a bit late.
As we know in this market top, leading
stocks went into breakdowns ahead of Nasdaq 100 peak. Just watching the Cubes,
you would have seen an ominous dry-up of volume going into the rally that took
the tradable fund to the March 24 high. Again, I prefer to use the moving
average crossover as a confirmation signal. There’s no escaping reliance on your
own judgment.
Jim
Whitner, managing director of
Glenwood Equity Investors, suggests this rule of thumb for traders caught
between deciding how much play to give the market before stopping out. At the
helm of the Stargazer One hedge fund, Whitner returned 170% in 1999.
“If you’ve got a huge profit in
your position, you may wait for the 10-day to cross below the 30-day to confirm
a change in the dominant trend and tell you to sell,” Whitner said.
“But if you have small profit, and you’re trying to avoid a big loss, you
may want to sell if the index crosses below the 10-day moving average.
“The
more sensitive your tolerance to risk, the more sensitive your indicator. It’s an inexact science, but it works for playing the big trends. Just adapt the
indicators for your risk-management strategy.”
In short, trading these trends not about being precisely right.
It’s about getting in soon enough and exiting soon enough to make money.
Part 1 in a series
of three. Also see
Part 2: How To Use RSI To Trade Index Funds and
Part 3: How to Short ETF Breakout Failures.
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