How to Use ETFs in a Trend-Following Strategy
December 17th, 2012 at 6:00am by Tom Lydon
Before committing to any exchange traded fund, investors should take the time to formulate a strategy or set entry and exit points to help minimize the emotional and often irrational aspects associated with investing.
For instance, some technical traders implement a type of moving averages strategy that would help identify trends and potential trend changes within an investment, writes Darrell Jobman for TraderPlanet. [S&P ETFs Holding 200-Day Average Fuels Holiday Rally Hopes]
Jobman outlines three main goals when verifying trend observations from a price chart:
- Direction. Trend traders will want to enter a position that will go in line with the trends. Consequently, they will track a trending or non-trending price pattern.
- Early bird special. Typically, traders will want to identify trends early to get in as early as possible.
- Egress. Lastly, traders should be able to pick out exit points on their trend following strategy.
The simplest and most widely used technical indicator is the moving average as it identifies trends by smoothing out market “noise,” points out areas where a trend begins or ends, and indicates shifting market momentum. When looking at the moving average, there are three different types to consider.
- SMA. The simple moving average covers the price over a specified period of time divided by the number of prices in that period to get the average. With each new price, the oldest price is dropped off – this is used in any 50-day, 200-day or other variant method.
- WMA. A weighted moving average provides a greater emphasis on the latest price. For instance, the last day may be given a higher multiplier applied to its price, whereas the oldest day would simply be its closing price.
- EMA. The exponential moving average also gives more importance to the most recent prices. The EMA would keep all the past price data and produces a smoother line, compared to the other moving averages, which is more noticeable in volatile market conditions.
At ETF Trends, we like to follow the 200-day EMA to guide us. When an ETF crosses above its 200-day EMA, it is a buy signal, but when the investment starts to dip below, it is time to exit. [An ETF Trend-Following Plan for All Seasons]
For more information on trends in ETFs, visit our trend following category.
Max Chen contributed to this article.
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.