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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