Trading Broad Based ETFs? Try Sector ETFs Instead

Recently we have begun to focus more on trading the sector-specific ETFs
rather than the broad-based ETFs such as
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PowerRating), [ DIA|DIA], or
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When the major indices are steadily trending in one direction or the other, the
broad-based ETFs are an ideal trading vehicle, but choppy and range-bound
markets are likely to result in many stop-outs of the broad-based ETFs. The
solution therefore is focus on specific industry sector ETFs that are showing
relative strength or weakness to the broad market, as we did by taking long
positions in BBH and SMH last month. Many people are interested in trading the
sector-specific ETFs, but don’t know which ones are ideal for short to
intermediate-term trading. If you fall into that category, the following
information we have prepared will be quite useful.

There are many different families of sector-specific ETFs, with companies
launching new offerings at a rapid pace, but we like to focus on sector ETFs
from three different families: HOLDRs, iShares, and Select Sector SPDRs.

One of the most popular family of ETFs belong to a group collectively known
as HOLDRs, an acronym that stands for HOLding company Depositary Receipts
(pronounced “Holders”). These securities represent ownership in the common stock
or American Depositary Receipts (ADRs) of specified companies in a particular
industry, sector or group. Issued by Merrill Lynch, there are currently 17
different HOLDRs. Of these, 15 track specific industry sectors and two track
broad market indexes. Although limited to only 15 industry sectors, many of the
HOLDRs have high levels of average daily volume, causing them to be favored by
traders.

Barclays Global Investors, the company that created the first index strategy
in 1971, launched the iShares family of exchange traded funds in the year 2000.
iShares have gained popularity because the family consists of broad-based,
industry sector, international, and fixed-income ETFs. However, the less popular
iShares sometimes have wide spreads due to light average daily volume levels.

There are 9 different sectors that comprise the Select Sector SPDR family of
ETFs, which is the same company that brought you the first domestic ETF; the S&P
500 Tracking Stock (SPY). Like the HOLDRs, the Select Sector SPDR family of ETFs
is small, but they are quite popular nonetheless.

There are a total of 51 different industry sector ETFs between the three
families discussed above, but we have narrowed this down to show you only the
ETFs within the three families that have a 50-day average daily volume of at
least 200,000 shares. Notice on the table below that some sectors, such as
Biotech, have more than one major ETF that tracks it:

Although the table above only lists ETFs that trade at least 200,000 shares
per day, don’t get too obsessed with actual liquidity issues in ETFs. Unlike
individual stocks, which you probably would not trade if the average daily
volume was too low, remember that all ETFs are synthetic instruments. As such,
you will notice that high average daily volume is less important for ETFs than
for individual stocks because the price manipulation that you typically see in
low volume individual stocks is not a factor with ETFs. This is because the
price of an ETF, whether a HOLDR, iShare, or SPDR will closely mirror the price
of the underlying stocks that comprise it. Therefore, even if no trades are
being executed in a low-volume ETF on a given day, the bid and ask prices will
rise and fall as the prices of the underlying stocks change. The table is
limited to stocks over 200k average daily volume only to give you an idea of
which sector ETFs are the most popular.

I also want to bring your attention to the two separate “Avg. Daily Vol.”
columns on the table above. The first column, “Avg. Daily Vol. (July 2005),”
obviously displays the current average volume for each ETF, while the column to
the right, “Avg. Daily Vol. (July 2003),” shows the average volume of those same
ETFs only two years prior. Of the 24 ETFs listed in the table, only 3 have seen
a decline in average volume from two years prior. The rest have all seen a major
increase, many sporting 300 – 400% (or more) surges in average volume within
only the past two years. Consequently, these numbers confirm any general
comments you may have heard about the recent growth of interest in ETFs.

The benefit of trading sector ETFs is even greater when the broad market
enters into a choppy, range-bound period, as the major indices were throughout
the latter half of May and all of June. Knowing which sector ETFs to choose from
is a good start, but you obviously need to have a basic strategy for determining
which sector ETFs will result in profitable trades. Providing you with all
the details would require me to write another book, but I will share one simple,
but highly effective method for selecting the strongest sector ETFs to buy or
the weakest ones to short.

After establishing which sector ETFs you will keep on your daily watchlist,
the next step is to determine which ones are showing the most divergence
(relative strength) to the broad market. You can do this by creating a watchlist
of your ETFs on your trading software, then by simply sorting the list of sector
ETFs by percentage change. We also include the percentage of volume each ETF has
traded, relative to its average volume, so that we can spot institutional buying
interest that is marked by volume surges. Below is a screenshot (with
yesterday’s closing prices) of the layout we use to follow the sector ETFs on
TradeStation:

If looking for sector ETFs with bullish trend divergence, pay attention to
how the ETF acts on each move the S&P
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Sector ETFs with relative strength will usually go sideways to slightly higher
when the S&P or Nasdaq drops, but will rocket to new highs on the slightest
bounce in the broad market. Conversely, short candidates should barely lift off
their lows when the S&P and Nasdaq rallies, and should fall to new lows on any
broad market weakness.

Upon scanning the watchlist above, you will quickly spot divergent prices
relative to the broad market. Obviously, we want to buy those sector ETFs with
the most bullish divergence (relative strength) and/or short those with the most
bearish divergence (relative weakness) to the broad market. The sooner you spot
the divergent trends, the less risk and higher profit potential for entering a
new ETF trade. We have found the best way to catch divergent trends in the early
stages is to become disciplined at scanning your watchlist at a regular
interval, depending on the type of trader you are. If you are looking for trades
with a three to five day time horizon, for example, you would want to scan for
sector trend divergence on a daily basis. But traders looking to enter trades
with a one to three month time horizon would benefit more from doing scans that
show weekly relative strength of the ETFs instead of daily. The frequency with
which to look for divergent trends depends on what type of trader you are.
Daytraders may prefer to follow the percentage changes on an intraday basis,
while longer-term trend traders (such as hedge funds like Morpheus Capital) will
look for relative strength on an end-of-day or weekly basis. Regardless of the
time horizon you trade, the concept works the same. However, greater trend
divergence that results in larger profit potential will obviously come from the
longer time periods.

When you spot these divergent trends early enough, you can enter the trade,
then simply trail stops to maximize your profits as long as the relative
strength remains intact. This is what we did with our recent winning trade in
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Even though we had a 17 point unrealized gain on the BBH position, there was no
reason to sell it because it continued to show relative strength to the broad
market. However, we continued trailing the stop each day and it eventually was
hit, leaving us with a 15-point net gain. Again, we emphasize that the same
techniques of relative strength work on much shorter time frames, even for
daytraders, but the divergence is often more clear on a longer-time frame.

One final note regarding the screenshot above is the column labeled “%
range.” In addition to simply plotting percentage price changes, we also like to
see where each ETF closed the week (or day) relative to its range of that time
interval. The closer each ETF closed to the top of its range, the more relative
strength it is showing. Conversely, ETFs that close near the bottom of their
ranges are showing the most relative weakness. After getting in the habit of
scanning all your sector ETFs at a regular interval which you determine, the
divergent trends will become apparent. If the same ETFs are showing bullish or
bearish divergence every time you do your research, a longer-term trend
divergence that occurs from institutional sector rotation is probably taking
place. Buying the sector ETFs with bullish trend divergence and shorting those
with bearish divergence enables you to ride along on the coat tails of
institutions who also realize the benefits of sector trading with ETFs.