How to Buy, Sell and Choose ETFs
February 17th 2009 at 1:00pm by Tom Lydon
We love hearing from our readers when they have questions about exchange traded funds (ETFs) or the trend-following strategy. This reader had specific questions about when we buy ETFs, when we sell them and how we choose them.
1. Is the 200-day moving average the SMA or EMA?
We use the 200-day EMA. What’s the difference? The simple moving average (SMA) is calculated by tracking the price of a security over a particular time period. The exponential moving average (EMA) involves a trickier mathematical formula which puts greater weight on the most recent price movement rather than an equal weight over past 200 days. The moving average you choose is a matter of personal preference, but the EMA is consistently closer to the actual price, which is why we use it.
2. When selling an ETF after it declines 8% from a high, do you set an 8% trailing stop loss order at the time of purchase?
Yes, this is what we do. A trailing stop loss order is when the stop loss is set at a fixed percentage below the market price. As the market price rises, the stop loss prices rises proportionately. If the price falls, the stop loss stays in place.
3. How do you determine when you buy an ETF back once the 8% trailing stop loss triggers?
Cash obtained from the sale of an ETF is considered a free agent – it can go anywhere you’d like it to, as long as the trend is there. Look at other sectors, asset classes and global regions – is anything else trending in the right direction? We have a daily report we use to track the 800-plus universe of ETFs, and we use it to spot these trends and help determine areas we should be exploring further.
And sometimes the trends just aren’t there, in which case, we keep cash on the sidelines until it’s safe to go back.
4. What ETFs are included in the portfolio and does the lineup ever change?
What ETFs we choose to include in our portfolio is simply a matter of where the trends are. We don’t employ an asset allocation model. Instead, we look at which funds are above their long-term trendlines (the 200-day moving average). We also consider other factors, such as assets, trading volume, any particulars of the sector or global region and so on before we make a buy.
And while we don’t employ traditional asset allocation, it is necessary to consider where you’re already invested. For example, if you’re holding an energy fund, you may not want to invest in Latin America or Russia, since those areas are heavily allocated toward the energy sector and could leave you overweight.
5. Does the 200-day discipline work the same for all ETFs?
The 200-day discipline can be applied to nearly any security, but it works especially well for ETFs. Having a buy signal at the 200-day moving average mark gives you a chance to have your money invested when a potentially new uptrend is beginning. Having a sell point that has you out when an area is below the 200-day or 8% off the recent high provides you the chance to get out before things could potentially worsen, while also working to protect any gains you may have had.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.