5 Ways to Identify Winning ETF Trades

ETFs (exchange-traded funds) enable investors to participate in directional moves in a range of 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, of 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 geo-political 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, or, in the case of commodity ETFs, 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 | Quote | Chart | News | PowerRating) when looking at the Retail HLDRs ETF (RTH | Quote | Chart | News | PowerRating) or Citigroup (C | Quote | Chart | News | PowerRating) when looking at the Financial Select Sector SPDR (XLF | Quote | Chart | News | PowerRating).

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 | Quote | Chart | News | PowerRating) provides an example of the interplay between technicals, fundamentals and macro analysis in making ETF trading decisions.

Homebuilders from January 2007 to January 2008 (the time of this writing) had been in a powerful, dominant downtrend for an entire year. In January 2007, the XHB was up near 40, while on January 9, 2008 the ETF hit a low of 15.22, which is a decline of about 60%. While that in and of itself is not a reason to buy anything, it is certainly a reason to keep a chart on your radar screen, because any index or stock that goes down 60% in a year, unless it's going to go to 0, is worth watching to see how the patterns develop into a potential bottom.

The XHB chart over the entire year showed 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. 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.

So the profile of the chart to me said, ok, this is accented to the downside, no doubt, and the bears certainly have control, but at some point there'll be one time or two times the XHB comes down towards the bottom of the channel, and, instead of hitting it, falls short of the bottom of the channel. That is to say it doesn't quite get down far enough. That will be my first clue, using channel analysis, that the XHB is starting to exhibit relative strength rather than relative weakness.

Sure enough, the decline from December 11 at around 22 down to the January 9 low at 15.22 failed to get to the bottom of the channel, which would have been a move to 14. Instead, it turned up and started to consolidate between 16 and 17 1/2.

At the same time, other oscillators, such as momentum, relative strength indices, and overbought-oversold gauges, were starting to turn up. Fundamentally, lots of bad news on earnings had come out about the homebuilders. Housing starts were disastrous. Housing permits were disastrous. Yet the actual price action of the XHB did not decline further even though the news on the housing sector, including the government statistics, continued to deteriorate.

So now I had certain reasons why the chart work was telling me to keep this very much on my radar screen for a possible upmove toward the top of the channel or beyond. The inability of the price action to react negatively to bad fundamentals caught my attention, as did the entire economic and Wall Street community clamoring for a rate cut. Added to this mix were the underlying components of the XHB. A look at some of the charts on those -- homebuilders, plus carpet manufacturers and painters, and retailers like Home Depot (HD) -- I came to the same conclusion that many of these names may be sold out also, and that there may be an upside surprise.

Sure enough in the third week of January, the XHB rocketed from the low 16s to a high on Wednesday, January 23 (the time of this writing) of 20.50. This not only took out the top of the channel, which was at 18.60, it also took out the declining 50-day moving average, which was at 18.68, signaling to me that the XHB could head considerably higher.

Price behavior within the year-long channel on the XHB gave me certain clues that the market was sold out, and nearing downside exhaustion. Using my experience in technical analysis, and applying various technical tools, I became increasingly confident that the XHB was approaching a significant counter-trend advance. It was only a matter of time and patience before I would be rewarded for establishing a countertrend long position.

So, in summary, some steps for identifying winning ETF trades are:

1) Identify patterns in a chart -- preferably of six months or more -- such as price hitting bottom of a downtrending channel.

2) Watch for a change of behavior, such as price not touching bottom of the channel.

3) Look for confirmation of the change in charts of key component stocks of the ETF.

4) Factor in fundamental news related to the ETF with an eye, for example, on bad news already built into price.

5) Overlay macro analysis, looking at, for example, the impact of Fed rate changes on interest rate-sensitive industries.

Waiting for an anomaly in the XHB chart pattern -- and gaining confirmation by comparing that to charts on component stocks, plus industry fundamentals and macro factors -- resulted in a winning ETF trade.

Michael Paulenoff is author of MPTrader.com, a diary of his technical chart analysis and trade alerts on ETFs covering a range of markets.