Choosing the Right ETFs for High Probability ETF Trades

Posted 06/22/2009, 9:00 am EST by David Penn from TradingMarkets.com

For some traders, trading is about a triad of three key questions: what to trade, when to trade (or, how to enter positions) and when to stop trading (or, how to exit positions).

In our introductory series on ETF trading, we have talked a great deal about the last two questions on entering and exiting positions. We know, for example, that high probability ETF trading is all about buying oversold ETFs above the 200-day moving average and selling short overbought ETFs below their 200-day moving averages.

We also know that when it comes to exits, we have a variety of tools at our disposal � from moving averages to the Relative Strength Index. But essentially we follow the same strategy as when we take positions � only in reverse: exiting long trades after they have moved from oversold back into strength and covering short trades after they have moved from overbought back toward weakness.

This covers getting into and out of trades. But how do we determine which ETFs to trade in the first place?

Our research on hundreds of exchange-traded funds looks at the entire price history of these ETFs since inception. This research has indicated that certain types of exchange-traded funds perform significantly better in our high probability ETF trading strategies than others. In general, this is because these ETFs have a greater tendency to revert to their mean, and are more likely to make short term reversals after reaching overbought or oversold extremes.

Country ETFs: Exchange-traded funds based on the stock markets of entire countries or regions have performed the best in our simulated ETF testing. These country ETFs range from ETFs based on U.S. indices such as the S&P 500 SPDRS ETF and the PowerShares QQQ Trust ETF to ETFs like the iShares FTSE/Xinhua China 25 ETF and the Market Vectors Russia ETF.

Among the more popular country funds is the iShares MSCI Brazil Index ETF which includes stocks from Brazil�s Bovespa exchange.

EWZ Chart

Sector ETFs: Sector exchange-traded funds (ETFs) include among their holdings stocks that represent a single industry group or sector such as the energy, financials or technology. Examples of some of these sector ETFs are the Financial Select Sector SPDRS ETF and the Vanguard Health Care ETF.

An easy way for traders to get exposure to stocks of major oil companies is through energy sector ETFs like the Energy Select Sector SPDRS ETF.

XLE Chart

Commodity/Currency ETFs: Exchange-traded funds that are based on commodities and international currencies are a popular way for stock and ETF traders to get exposure to the commodity and currency markets without needing futures or forex accounts. Commodity ETFs include funds like the SPDRS Gold Shares ETF, which tracks the price of gold bullion rather than the share prices of gold mining companies, and the CurrencyShares Euro Trust ETF, which follows the price of the Euro currency.

We have found that commodity and currency ETFs have performed less effectively in our high probability ETF trading strategies. This is not to say that these ETFs cannot be used with our strategies. But we have found that the edges are significantly greater when ETF traders stick to the more mean-reverting ETFs among the country and sector funds. When looking to make high probability ETF trades, we encourage traders to look and select from among the wide � and growing � array of country and sector ETFs available to traders.

David Penn is Editor in Chief at TradingMarkets.com.