ETFs

How to time ETF buying decisions

When you trade exchange traded funds, you can choose from two primary types of entries, depending on the chart pattern of the actual trade setup.

The first type is called a “breakout entry,” meaning you are buying a rally above some key area of price resistance. The second is called a “pullback entry,” which you buy when a steadily trending ETFs retraces to an area of major support. Many technical traders say a stock or ETF is “breaking out” only when it moves to a new high.

For the purposes of this discussion, however, a breakout simply indicates that the position has surged above a significant area of price resistance. The breakout could occur above consolidation (typically at a new high) or above a downtrend line.

For short positions, the term that applies is “breakdown entry,” which is simply the opposite of a breakout. Breakdowns occur when an ETF falls below an area of price consolidation (support) or when it breaks down below an uptrend line. This discussion is focused primarily on long entries. The same concepts apply on the short side, except everything is the opposite.

Of the various breakout entries, breakouts to new 52-week or multiyear highs typically yield the greatest amount of profit potential. If you ponder the mind-set of the typical retail investor, it makes sense why this is the case.

When the average investor is faced with a position that moves lower after his entry, he falls into “hope” mode. Rather than taking the route of a professional trader and simply cutting the loss when things start to look bad, he nervously hopes that his position just “comes back to break-even” so he can sell with no damage done.

Not only is this way of thinking quite destructive to his bottom line, but this exact thought process is what creates horizontal price resistance levels in the market. If an ETF hovers around the $80 level for several weeks and then suddenly falls to $72, all the investors who bought at the $80 area now shift into hope mode, waiting for the ETF to return to near their entry price.

When it does (if it does), they immediately launch their sell orders in order to scratch the trade. This overhead supply, created by an abundance of people attempting to sell at the same time, produces areas of price resistance that must be absorbed before a stock or ETF can move higher.

Only when the actual demand of people buying the ETF exceeds the overhead supply can the ETF eventually move above the specific level of price resistance.

Although an ETF is synthetic, the underlying components tend to move in lockstep, with investors managing the individual stocks the same way. This causes ETFs to act very much like stocks. When a stock or ETF is trading at a new high, it typically goes much higher than the average investor would expect it to before pulling back and catching its breath. This is simply due to the complete lack of overhead supply.

If the position is at new highs, there are no investors trapped at higher prices who immediately sell into the strength of the first rally.

Novice traders and investors tend to avoid ETFs at new highs because they have been conditioned over the years to “buy low, sell high.” But the reality is quite different. ETFs at new highs tend to motor much higher because it doesn’t require a lot of demand to push equities higher when the overhead supply is so minimal.

Although ETFs at new highs yield a lot of profit potential when they follow through, which is a majority of the time, the downside is that they can also reverse quickly if the breakout to a new high fails. This occurs when an ETF briefly moves, or “probes,” above the prior high, maybe even closes above it for a day or two, but comes back down just as quickly. When this happens, it’s important to have a firm plan for quickly exiting the position.

When a breakout fails, the downward reversal (or upward reversal if shorting a breakdown to a new low) can be fast and furious. This is because all the professional traders who quite properly bought the new high suddenly find themselves trapped.

Their astute nature mandates they immediately cut the loss and wait for another breakout attempt. This of course creates a wave of downward momentum. In turn, that downward momentum grows as short sellers who noticed the failure join in the selling party.

The profit potential for buying a breakout above an established downtrend line is typically less than it is for buying a breakout to a new high. This is because the position must still contend with overhead supply left behind in the wake of investors who bought at higher prices. Nevertheless, the benefit of this type of entry is that the reward/risk ratio is often much greater.

On a new long entry above resistance of a downtrend line, the risk is minimal, especially if higher volume confirms the reversal of fortune. This is because resistance of the clearly defined trend line should become the new support level after the resistance is broken.

The most basic tenet of technical analysis states that a prior area of resistance becomes the new level of support after the resistance is broken. Because of this, you can place a protective stop just below new support of the prior downtrend line. If the reversal above the downtrend line holds, the downside risk is minimal compared with the profit potential of a rally back to the prior high from which the current downtrend began. Often, reward/risk ratios can exceed 3- or 4-to-1. Anything over 2-to-1 is better than average.

With breakouts to new highs, you want to buy the position immediately after it moves at least 10 cents to 20 cents above the prior high (depending on the volatility of the ETF). With breakouts above downtrend lines, however, your entries should be intentionally slower as you look for confirmation that the trend reversal will hold.

Rather than blindly buying the first break of the downtrend line, wait for the first minor retracement that follows. The idea is to make sure that the pullback does not breach new support of the prior downtrend line. If it does, the reversal attempt was likely a “fake-out” to reel in the bulls.

Conversely, a minor pullback that holds above the prior downtrend line provides a low-risk entry point with a high probability of moving upward. After the first dip that follows the break of the downtrend, you want to buy as soon as the ETF trades above the prior day’s high.

PULLBACKS

For long positions, a pullback entry is based on the concept of finding an ETF with a clearly established trend, and then waiting for the first retracement (pullback) down to support of either its primary uptrend line or moving average.

For short positions, it’s the opposite scenario, as in selling short a steadily downtrending ETF when it rallies into resistance of its downtrend line or moving MAs.

With pullback trading, it’s critical to ensure that a clearly defined trend is already in place. Otherwise, you risk entering the trade in no man’s land by getting in too early. A clearly defined trend means you are looking for at least two higher highs and two higher lows for longs (two lower highs and two lower lows for shorts).

Starting from the ultimate lowest price since the start of the new trend, the higher lows are formed when each pullback reverses back up after forming a higher price than the previous low. The same is true of a higher high.

This trend will also form at least three individual anchor points connecting the highs and lows. The time frame of these highs and lows depends on the time frame of your trades.

A key point here is to remember a basic rule of trend trading: The longer a trend has been intact, the more likely the established trend will continue in the same direction. If an ETF has been steadily trending higher for six months, forming successively higher highs and higher lows, odds are much greater that it will continue higher as compared with an ETF that has been trending higher only for one month. This is largely the result of trend line support’s becoming a self-fulfilling prophecy.

When professional traders see support of a trend line, they place their buy orders in anticipation of a resumption of that trend line.

The very act of their doing so is largely what causes trend lines to work as a method of low-risk trade entry.

It’s essentially a self-fulfilling prophecy.

Here again, you must sometimes fight the urge to let human nature dictate its logic.

When I was a new trader, I constantly avoided long-established trends, thinking I was too “late to the party” for a low-risk entry.

In the beginning of learning technical analysis, it’s normal to think this, but it’s faulty thinking.

Remember that steady trends are formed through institutional buying of individual sectors.

When the “big boys” start buying stocks within a particular industry, they typically continue throwing their money in that area until the next promising idea comes along.

You need only look at recent charts of the oil and utilities sectors to see that institutional money flow can often continue for years.

Of course, there is always the risk that your pullback entry may also coincide with the end of the trend, but this pullback method of entry helps to minimize that risk.

Though it may be tempting to do so, avoid new trade entries on their first test of price or trend line support.

Rather, stalk the setup like a sniper, waiting for the first sign of confirmation that the currently established trend is ready to resume.

Doing so decreases your risk of stopping out immediately after your entry.

To look for confirmation on pullback entries, you simply drill down to the next-lowest time frame and then look for a breakout above resistance.

If, for example, you are looking to buy a pullback to trend line support on the daily chart interval, you would subsequently wait for the newly formed hourly downtrend line to break.

When it does, you then enter the position in anticipation of a ride back to the prior highs and onward.

If the pullback comes but never moves back above resistance of the shorter time frame, you simply don’t enter the trade.

Basic trend lines work great for pullback entries, but the 20-day MA is another useful indicator, as buyers tend to step in immediately upon the test of the 20-day-MA support with strongly trending ETFs.

Note that the best-trending ETFs can go many months without ever retracing down to their 50-day MAs. If the 20-day MA happens to converge with support of the trend line, that’s even better.

Due to large changes in over-night supply or demand, the major market indexes, individual stocks and ETFs often open much higher or lower than where they closed the previous day, which is known as a “gap.”

Buying long or selling short an ETF that hits its trigger price due to an opening gap is sometimes riskier than entering an ETF that trades through its trigger price in an orderly fashion.

Likewise, open positions sometimes gap open beyond their stop prices but immediately reverse in the right direction.

The following rules will help you manage positions that gap open beyond their trigger or stop prices:

• ETFs that gap open beyond their trigger prices. For a long setup, buy the ETF only if it subsequently sets a new high after the first 20 minutes of trading.

For a short setup, sell short the ETF only if it subsequently sets a new low after the first 20 minutes of trading.

In both cases, the ETF must exceed its 20-minute high (for longs) or 20-minute low (for shorts) by at least 10 cents before you enter the position.

Also, don’t follow the gap rules for any opening gap of less than 10 cents above or below the trigger price.

• ETFs that gap open beyond their stop prices.

If a long position gaps down to open at or below its stop price, continue to hold the position for the first 20 minutes of trading, at which point the new stop price is adjusted to 10 cents below the low of the first 20 minutes.

For short positions, adjust the stop to 10 cents above the high of the first 20 minutes.

The above rules are designed to keep you out of trouble by preventing you from entering or closing a trade at the worst price of the day.

Nevertheless, just like every other rule in trading, there are always exceptions that enable experienced traders to deviate occasionally from these rules with high success rates.

These nuances cannot be taught but can be learned only through experience.

These rules are designed to avert major losses, which is much more important than whether you leave some profit on the table or not.

BREAKOUT OR PULLBACK?

By now, you may be asking yourself: Which type of entry is better, a breakout or pullback? The answer depends on two factors: overall broad market conditions and personal comfort level.

Breakouts work better in certain types of markets, while pullback entries can be utilized effectively in nearly any market environment. The most important thing to realize when buying breakouts is that they have a much higher rate of success in bull markets than in choppy, range-bound markets. Similarly, breakdown entries are more successful in steadily downtrending or bear markets.

Approximately 80% of stocks follow the general pattern of the major indexes.

Therefore, it is not prudent to attempt breakdown short entries in raging bull markets, nor is it wise to buy breakouts in weak markets. While doing so occasionally works, why fight against the odds?

Go with the overall trend and you’ve automatically increased your chances for a profitable trade dramatically.

Choppy markets yield a low batting average for both breakouts and breakdowns, as there is usually a tug of war going on between the bulls and bears.

If you are buying breakouts and you find yourself continually getting “chopped up,” or realizing an overall large loss through a series of small losses, take an objective look at overall market conditions.

Chances are that you’re attempting to do so in the midst of an indecisive, possibly quite erratic broad market.

Stick to steadily trending markets, always trading in the direction of the overall trend, for the highest chance of success when buying breakouts or short-selling breakdowns.

Although you might be inclined to dismiss the idea of individual personality’s being a relevant factor in trading, don’t underestimate its importance.

If you’re the type of person who is always thinking that an ETF at new highs is overbought or too expensive, buying breakouts to new highs is probably not a good idea. You’ll either find yourself selling the position too early, missing most of the profit potential or selling the position at the first hint of a potential short-term correction.

Buying a trend reversal or a break of a downtrend line may be better-suited to your personality. There’s nothing wrong with that, as both types of entries have distinct advantages.

Be honest with yourself and act on your instinct.

Deron Wagner is the founder and head portfolio manager of Morpheus Capital LP and Morpheus Trading Group in Cooper City, Fla.