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A Winning ETF Trade


Profit by employing technical, fundamental analysis.


Exchange-traded funds, or ETFs, enable investors to participate in directional moves in subsets of the major market indices. ETFs have been developed for essentially every U.S. industry, many countries, commodities, Treasuries, currencies and even the inverse (short side) of many of these market areas.

I trade ETFs with a short-term horizon -- one session to two weeks -- identifying directional price movement from 2-8% based on:

1) Technical chart analysis
2) Fundamentals underlying those charts and
3) My perception of what the macro-economic and geopolitical worlds looks like.

Technical chart analysis involves both pattern recognition and evaluation of the underlying technical indicators. I look at charts of the ETF itself, plus related charts such as, in the case of equity ETFs, the top five largest component stocks. In the case of commodity ETFs, I look at the futures contracts, which give a 24-hour picture of the market action.

Fundamentals often relate to company and industry news stemming from the key component stocks, like Walmart (WMT) when looking at the Retail HLDRs ETF (RTH) or Citigroup (C) when looking at the Financial Select Sector SPDR (XLF).

Macro factors, which help identify the ETFs on which to focus, include interest rates, Federal Reserve decisions, trends in the dollar, and movements in bonds and yield curves, plus the interplay of these and many other crosscurrents.

A look at the Homebuilders ETF (XHB) provides an example of the interplay between technicals, fundamentals and macro analysis in making ETF trading decisions.

Homebuilders from January 2007 to January 2008 had been in a powerful, dominant downtrend for an entire year. In January 2007, the XHB was up near 40. On January 9, 2008 the ETF hit a low of 15.22 - a decline of about 60%.

While a drop like that in and of itself isn't a reason to buy anything, it's certainly a reason to keep a chart on your radar screen. Any index or stock that goes down 60% in a year, unless it's going to go to zero, is worth watching to see how the patterns develop into a potential bottom.

The XHB chart over the entire year shows that every move up and down created a stair-step decline. Connecting the tops of the rallies and bottoms of the declines illustrated the major down-channel (see below).

Click to enlarge image

Constantly studying the chart, I noticed that on the declines I could expect the XHB's price to probe the bottom of the channel, go right to the lower support line, sit on it, and maybe even break it by a 1/2 percent. By contrast, on the topside, on every rally, the XHB barely was able to rally 60% of the width of the channel to the top part of the channel.

In other words, rallies failed to get to the top part of the channel, but declines always seemed to land smack on the bottom of the channel, flirt with breaking it, but manage to hold.

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No positions in stocks mentioned.
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