How to Find and Trade Overbought and Oversold ETFs, Part 1

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

How do you trade exchange-traded funds (ETFs)?

ETFs are an exciting market for traders. ETFs allow traders to trade whole markets or financial sectors. ETFs also make it possible for traders to avoid single stock risk and to hedge investments in other instruments, from stocks to bonds to commodities.

But what opportunities do exchange-traded funds (ETFs) offer traders - especially short term traders?

We have done extensive research into exchange-traded funds, in some instances, backtesting ETF trading strategies all the way back to the mid-1990s. And what our research has uncovered with regard to exchange-traded funds (ETFs) parallels what we have discovered when it comes to stock price movement in the short term:

There is a short term edge in buying oversold ETFs above the 200-day moving average, and in selling short overbought ETFs trading below the 200-day moving average.

Overbought to Sell-Off: Short Term Highs Below the 200-day Moving Average Lead to Downside Opportunities for Traders

SPY Chart

Let's say that again because it is the crucial aspect of our high probability approach to trading exchange-traded funds in the short term: when ETFs are trading above their 200-day moving averages, we look to buy them on pullbacks after they have become oversold. When ETFs are trading below their 200-day moving averages, our strategy is to sell them short on bounces after they have become overbought.

Are you new to exchange-traded funds (ETFs)? Be sure to read our ETF primer, ETF Basics: What You Need to Know About Exchange-Traded Funds.

If that sounds simple, then you're right: it is simple. But that's the way we like our short term trading strategies.

Our approach to short term trading - in ETFs as in stocks - is simply to uncover an edge, a natural tendency in the markets, and then to look for ways to take advantage of that edge through timely trades. It is a natural tendency of markets to move from overbought conditions to oversold conditions and back again. This happens during market rallies, market declines and even when markets are moving sideways.

Oversold to Rally: The 2-period RSI is One Excellent Tool for Short Term Traders Looking to Identify Overbought and Oversold Markets

REW Chart

What our research has revealed is that traders can take advantage of this natural tendency by trading these markets in the short term - buying markets after they have become oversold, but before they resume their advances back toward overbought conditions. On the short side, we found that it was possible to make high probability, high win-rate trades by selling short markets after they have become overbought, but before they begin their inevitable short term sell-off.

All that is required to do this are two things: the 200-day moving average (we never buy ETFs below it and never sell short ETFs trading above it), and a way to determine when an ETF has become overbought or oversold. On Thursday, I will share with you one simple strategy for determining whether or not an ETF is overbought or oversold. Next week, on Tuesday, I will present a second - even more powerful - tool that will help you spot overbought and oversold opportunities in ETFs.

David Penn is Editor in Chief at TradingMarkets.com.