ETF Terms: Digging In On Some Technical Trading Frequently Asked Questions
Stoyan Bojinov: The growth of the ETF industry has spawned numerous tools that bring forth previously difficult-to-reach corners of the market at the fingertips of mainstream investors. The evolution of the exchange-traded product structure has not only become the preferred vehicle for investors looking to achieve cost-efficient diversification, this instrument has also struck a chord with active traders. ETFs are useful as building blocks in long-term portfolios, however they can also serve as incredibly powerful tactical tools for those looking to implement shorter-term trading strategies.
The trading community has embraced ETFs given their unparalleled transparency, cost-efficiency, ease-of-use, and intraday liquidity. Likewise, technical analysis studies used in the equity market have also carried over to ETFs; traders and investors alike can serve to benefit from using technical analysis in their ETF investment experience [see alsoFree Report: How To Pick The Right ETF Every Time].
The guide below offers an insightful and educational look at the concepts behind technical analysis; covering the most popular terms and tools while also providing relevant ETF trading examples.
- Trading Trends
- Moving Averages
- General Indicators (Osillators, RSI, MACD, Williams %R)
- Fibonacci Retracements
What Is Technical Analysis?
Technical analysis is the study of historical market data, including price and volume, used for forecasting the direction of a security. This discipline revolves around the analysis of charts to identify meaningful price action, confirm trends, spot trading patterns, predict potential reversal points, as well as assist traders and investors alike in setting price targets for entry and exit points.
The defining assumption of technical analysis is that price discounts everything. This means that the current market price for a security reflects all of the underlying fundamental factors which may have an influence on it. For example, the stock price of a company is indicative of what investors are willing to pay today, while also factoring in future growth expectations and the general sentiment of the market. Technical analysis is not concerned with finding the intrinsic value of a security, rather it is the study of historical patterns to predict future price movements. Technical analysis can be applied across any time frame for virtually any security, including: stocks, bonds, commodities, futures, and ETFs.
The other assumption of technical analysis is that price action will tend to repeat itself over time because investors collectively engage in patterned behavior. In other words, technical analysis assumes that history will repeat itself in the sense that observable price patterns are cyclical in nature [see BRIC-Or-Bust ETFdb Portfolio , or sign up for a free Pro trial].
How Is Fundamental Analysis Different From Technical Analysis?
Most are familiar with fundamental analysis which is the study of a company’s financial health through the analysis of underlying factors, commonly called “fundamentals”; these can include earnings, cash flow, quality of management, competitors, and operating advantages. Fundamental analysis strives to determine the intrinsic value of a security whereas technical analysis is only considered with price action. For example, when there is a sharp sell-off in a given stock, the fundamental analyst would likely look for reasons as to why the company’s share price dropped. The technical analyst on the other hand is only considered with asking how this price movement fits into the ongoing trading pattern which he is tracking.
Fundamental analysis is more common among investors with a long-term horizon, whereas technical analysis is more prominent among traders. An investor will generally do his homework on a company from top-to-bottom before buying stock, while a technical trader is more inclined to buy and sell out of positions with no concern for what the underlying business actually does. Despite the core differences between fundamental and technical analysis, many investors will rely on various technical indicators, such as moving averages, momentum, and support and resistance levels in helping them set price targets for entry and exit points [sign up for the free ETFdb newsletter].
What Is A Chart Pattern?
The first step to technical analysis is looking at the price chart for the given security. Chart patterns are observable price movements which are cyclical in nature over various time horizons. By studying the historical behavior of a security, experienced technical analysts may be able to predict where the price is likely headed based on the extrapolation of observable chart patterns.
What Is A Trend?
A trend is the prevailing price momentum for a given security. Simply put, this is the general direction of where a security is headed. By identifying the current trend of a security, investors and traders alike may have a better idea of where the price will be headed in the near future; the most common are uptrends and downtrends. Securities can also be stuck in trading ranges or oscillate within trading channels.
What Is An Uptrend?
An uptrend is when the price of a security posts a series of higher-highs and higher-lows. See chart below.
What Is A Downtrend?
A downtrend is when the price of a security posts a series of lower-highs and lower-lows. See chart below.
What Is A Trading Range?
A trading range is an area on the chart bound by parallel support and resistance lines in close proximity. The price of a security is said to be “stuck” in a range if it oscillates between well defined support and resistance levels. See chart below.
What Is A Trading Channel?
A trading channel is an observable pattern in which the price of a security will stay within a range, defined by parallel support and resistance lines, while still moving in a uptrend or downtrend over a longer time frame. If the trading channel is more-or-less sideways, the security is deemed to be in a trading range.
See chart below for an upward trading channel.
See chart below for a downward trading channel.
What Is A Trend Reversal?
A trend reversal is when the prevailing price momentum changes direction. This reversal can be a positive or a negative change in price. See chart below.
What Does A Trend Reversal Mean For ETF Traders?
Traders should keep an eye on prevailing trends and take note as prices deviate because spotting a trend reversal can present an attractive opportunity. For example, if a trader notices that an ETF in an uptrend is approaching a historically significant resistance level, they may wish to take profits from their long position; this is because the trader anticipates that history will repeat itself and a trend reversal will follow as the ETF attempts, and ultimately fails, to break above the said price resistance level.
Spotting a trend reversal can also help traders identify lucrative buying opportunities. For example, if an ETF has been in a downtrend, while its share price has held above a historically significant support level, some traders may wish to establish a long position; this is because the trader anticipates that history will repeat itself and a trend reversal will follow as the ETF bounces off the said price support level.
Forecasting a trend reversal is an incredibly difficult task that few should even attempt; this is a speculative practice because prices don’t necessarily have to reverse right at historically significant support and resistance levels as they have in the past. Traders should remember that history does not always have to repeat itself in the same way.
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How Are Trends Useful For ETF Trading?
Identifying and distinguishing between uptrends, downtrends, trading channels, and trading ranges can help ETF traders have a better sense of where prices may be headed. Simply put, spotting a trend in a chart can be quite valuable; by being aware of prevailing price momentum and observable patterns, investors and traders alike can fine tune their entry and exit price targets based on the underlying trend at hand.
For example, if you are bullish on a particular ETF which has been climbing higher and higher in price, utilizing simple trend analysis may help you accomplish your goal of establishing a long position by simplifying the timing aspect of the trade, which is often times by far the most difficult task. Consider the chart below.
By correctly identifying and drawing the prevailing upward trading channel, traders can more effectively time their entry and exit. Noting the bottom and the top ranges of the trading channel is important since it gives traders a better sense of when it is attractive to buy and also when it is wise to take profits and sell. Taking careful note of the prevailing trend can help make your trades more profitable over the long run as your entry and exit points are based on a disciplined analysis rather than emotions and speculations.
What Is A Long Position?
This is when an investor owns a security, in anticipation that it will appreciate in value. Establishing a long position, or “going long”, simply means to buy shares of the given ETF. Investors can exit, or close, a long position by selling it; the profit on a long position is calculated by taking the difference in price at which you exited the position minus the price at which you entered. Similar to stocks, long positions in ETFs have a maximum loss equal to your initial investment.
What Is A Short Position?
This is when an investor effectively sells borrowed shares of a security, in anticipation that it will depreciate in value; one may choose to do this so they can eventually buy back the borrowed shares when they have to return them at a lower price than they sold them for, making a profit on the transaction. Establishing a short position, selling short, or “shorting” and ETF, all suggest that an investor has a pessimistic outlook for the given security as he is making a bet that it will decline in value. Investors can exit, or close, a short position by buying back the borrowed shares, which is also known as covering your short position. The profit on a short position is calculated by taking the difference in price at which you entered the position minus the price at which you exited.
Short positions entail significant risks for the simple reason that you are exposed to potentially unlimited losses. Consider this, when you establish a long position in an ETF at $10 a share for example, in a worst case hypothetical scenario, the price of the security can decline down to zero, and you would lose your entire initial investment. With short positions however, it’s possible to incur detrimental losses in the blink of an eye; because you must eventually buy back the ETF in the open market in order to close a short position, if you shorted at $10 a share, and the price jumps to $30 a share, you will have to incur a loss that is double that of your initial proceeds.
What Is A Rally?
A rally is another term used to describe a rise, or appreciation, in the price of a security. When an ETF rallies it means there are more buyers than sellers in the market and the share price is bid up.
What Is A Correction?
A correction is another term used to describe a sell-off, or decline, in the price of a security. When an ETF corrects it means there are more sellers than buyers in the market and the share price is bid down.
What Is Volume?
This is the number of shares traded in a security over a specified time period. Trading volume can be used as an indicator for gauging the market’s interest surrounding a given ETF. Simply put, a higher volume indicates more trading activity in an ETF.
How Is Volume Important For ETF Traders?
Trading volume represents the sheer number of shares which have exchanged hands in a specified period and thus it can be used to measure the underlying strength of a price move. Taking note of prevailing price and volume trends can help traders make more informed decisions and avoid potentially sour situations.
For example, if an ETF has been climbing higher in price everyday for the last week, while trading volumes have been steadily decreasing, it may be a good time to reassess the uptrend. Because trading volume is indicative of interest in a particular security, it’s worrisome when the price of an ETF appreciates rapidly while the underlying buying interest for the fund remains unchanged or even drops off. A rise in prices accompanied with falling volume is often times used as warning sign for a correction to come. See chart below.
Likewise, if an ETF has dropped in price while trading volumes have been steadily increasing, it may be wise to exit any long positions and reassess the trend at hand. Because trading volume is indicative of interest in a particular security, it’s worrisome when the price of an ETF drops while the volume rises because it means that selling pressures are accelerating, which can lead to a bigger-than-expected correction. See chart below.
In the ideal chart pattern, volume should move with the prevailing price pattern; this means that when an ETF is an uptrend, trading volumes should be increasing (and vice versa). When this relationship deteriorates and price and volume start to diverge, it can be interpreted as a sign of weakness in the trend at hand, which can potentially help in the prediction of a trend reversal [download 7 Cheap ETF Portfolios--fast, free signup].
What Is Support?
This is the price level which a security has historically had a difficult time closing below. Consider an ETF which is falling in price and as it approaches a certain price level, selling pressures subside and buyers step in again; this price level is referred to as support. See chart below.
What Is Resistance?
This is the price level which a security has historically had a difficult time closing above. Consider an ETF which is rising in price and as it approaches a certain price level, buying pressures subside and sellers step in again; this price level is referred to as resistance. See chart below.
How Are Support And Resistance Levels Useful For ETF Trading?
Support and resistance levels are useful for helping traders to identify more attractive entry and exit points based on historical price behavior. By spotting potential support and resistance price levels, traders can have a better sense of when it is attractive to buy into an ETF and when it is wise to take profits and sell. Additionally, support and resistance levels can also potentially help to identify trend reversals.
As an ETF approaches a historical level of support, traders should take note of its behavior. If the price holds at the support level for a given period of time, depending on individual risk tolerance, traders can anticipate that the ETF will not drop below this level for the time being and may wish to establish a long position accordingly. See chart below.
Likewise, traders should also take note as an ETF approaches a historical level of resistance. If the price struggles to break above the resistance level for a given period of time, depending on individual risk tolerance, traders can anticipate that the ETF will not climb above this level for the time being and may wish to take profits or establish a short position accordingly. See chart below.
What Is Profit Taking?
This is the action of collecting gains on your position. For long positions, it means you are selling shares at a higher price than you purchased them for, essentially locking-in a profit. For short positions, it means you are buying back shares at a lower price than you borrowed them for, again locking-in a profit.
The term profit taking is commonly used to describe a correction during an uptrend. This is because sustainable rallies require a steadily increasing support level, which means that traders can sell their position and collect gains from time to time while the longer-term uptrend remains in-tact. See chart below.
What Is A Stop-Loss?
This is a type of order placed with your broker which gives the command to close a position in a given security once a certain price level is reached. A stop-loss order is intended to help investors and traders limit their risk and minimize potential losses in a given position. For long positions, a stop-loss is an order to sell the ETF if the share price drops below a specified price level, thus ensuring that potential losses cannot exceed the calculated amount. For short positions, a stop-loss order is an order to buy back the ETF if the share price climbs above a specified price level, thus ensuring that potential losses cannot exceed the calculated amount [bookmark the free ETF screener; Pro members can download results to Excel].
For example, an open long position in an ETF at $100 a share with a stop-loss at $90 a share, simply means that if the price drops and hits the $90 level, the underlying position will automatically be sold then.
Why Are Stop-Loss Orders Important For ETF Traders?
Stop-loss orders can help traders manage their risk by giving them control over their potential losses. Because stop-loss orders are open, meaning they won’t be executed until a specified price level has been reached, they can ease the burden of managing a portfolio with many positions. In addition to better risk management, stop-loss orders should not be overlooked for the simple reason that they are free to implement; you only pay commission once your stop-loss order has been triggered, but the peace of mind that comes with knowing your losses will be cut in case a correction strikes costs nothing.
Stop-loss orders are important for ETF traders is because they allow for objective decision making. Stop-loss orders are purely instructions to close a position when a specified price has been reached; this ensures that traders can stick to their rules and take losses on a position when it drops below a predetermined level, which effectively takes out any emotions that may influence the decision. Traders can sometimes fall in love with an ETF so to speak and be unwilling to cut losses even when their analysis may suggest to do so. With stop-loss orders, traders can guarantee that they will stick to their rules and sell a security once losses from the position reach a predetermined level.
How Can Stop-Loss Orders Help ETF Traders?
For traders with a long position in a given ETF, a stop-loss order can protect you from unwanted losses by allowing you to manage your position according to your personal risk preferences. For example, consider a long position in an ETF at $100 a share with a stop-loss at $90 a share. You can have the peace of mind that your maximum loss for this position will not exceed $10 a share, which can be quite valuable in case selling pressures unexpectedly accelerate and the price collapses below $80 a share.
Suppose an ETF is in an uptrend and you wish to establish a long position, but are worried that you may be jumping in near the top of the trend. Using a stop-loss order can alleviate some of this stress while still allowing you to establish the desired long position. Consider the chart below.
Someone who buys at $66.50 a share may wish to protect themselves in case their positions turns sour unexpectedly. By setting a stop-loss order just below the previous support level at $64 a share, traders can guarantee that their losses will not exceed $2 per share even if a major correction develops.
Stop-loss orders are also critical for traders looking to establish short positions. When a trader opens a short position, they are effectively exposed to unlimited losses because the price of a security can theoretically climb higher without a ceiling. Stop-loss orders for short positions can be thought of as instructions to close the position by buying back the borrowed shares once the price of an ETF climbs above a specified level. Consider the chart below.
Someone who wishes to short the ETF at $78 a share may wish to protect themselves in case their analysis proves wrong and the security begins to trade higher. By setting a stop-loss order at $82 a share, traders can guarantee that their losses will not exceed $4 per share in case there is a rally which sends the ETF higher. Simply put, stop-loss orders are an easy and effective way to manage your risk by allowing you to determine exactly how much you are willing to lose on a position before you close it.
What Is A Trailing Stop?
This is a stop-loss order which is set at a specified percentage level below the market price of a security. In essence, this is a flexible sell order which is adjusted as the price of a given ETF fluctuates. A trailing stop order is intended to help investors and traders limit their risk by maximizing profits as well as minimizing losses. For example, lets suppose you purchase an ETF at $100 a share and set a 10% trailing stop. Your trailing stop order using the above example would kick in at $90 a share ($100 x 10% = $10, $100 – $10 = $90). If the ETF starts rising, your trailing stop will automatically adjust itself based on the market price. For example:
- at $110 a share, the trailing stop would be at the $99 level
- at $120 a share, the trailing stop would be at the $108 level
- at $130 a share, the trailing stop would be at the $117 level
How Is a Trailing Stop Different From A Stop-Loss Order?
A trailing stop order is flexible and automatically adjust itself relative to fluctuations in the market price. A stop-loss order on the other hand is static, in the sense that the specified price level remains unchanged, regardless of any fluctuations in the market price of a given ETF.
What Is A Price Target?
This is the projected level at which an investors is willing to close his position. For long positions, when the said price target is reached, the trader will sell his shares and ideally maximize potential profit. For short positions, when the said price target is reached, the trader will buy back the borrowed shares.
What Are Technical Indicators?
Technical indicators are tools used in technical analysis which offer a quantitative interpretation of the price of a security. These indicators are a collection of points that are generated by applying a formula to the price data of a security and can also include other factors like volume. These tools are used to anticipate future price movements in addition to confirming trends as well as forecasting potential trend reversals. Simply put, technical indicators are tools used to analyse price direction by extrapolation of historical price data and observable patterns. This set of tools can be further divided into leading and lagging indicators.
Because technical indicators fall under the umbrella of technical analysis, these tools offer no fundamental insights and may have limited use for long-term investors. This is because technical indicators are only concerned with price action; the underlying assumption is the same as that for technical analysis, which is that price discounts everything. Technical traders rely on technical indicators for their analysis, whereas investors will likely utilize these tools less frequently. Another way to think about technical indicators is to look at them as statistics which offer insights on current market conditions and may also be used to forecast future price movements.
Technical indicators should not be treated as perfectly accurate tools because they are purely statistical formulas. Nonetheless, these tools have a wide range of applications in the field of technical analysis, while investors can also utilize them to help with timing their entry and setting price targets.
What Are Leading Indicators?
Leading indicators are technical indicators which give signs of a potential trend reversal before the new trend occurs. Leading indicators are useful because they can help ETF traders spot upcoming corrections, rallies, and reversals, which can lead to more profitable trades. The greatest appeal of leading indicators is their ability to generate early signals for entry and exit, which can ideally help traders to buy right before a rally and sell right before a correction.
It’s important to remember that these tools are not always accurate as they are purely statistical formulas; perhaps the greatest drawback of leading indicators is that they tend to give numerous “false signals” so to speak. Its not uncommon for a leading indicator to give an early “buy” signal for example, when in reality the price of the ETF will continue lower in the days following. Likewise, a leading indicator may also give a false “sell” sign and prompt a trader to take profits on a position, when in reality the price of the ETF will continue higher in the days following.
Examples of leading indicators include: Stochastic Oscillator, Williams %R, Ultimate Oscillator, and RSI.
Traders should not rely on any one leading indicator as their only source of conviction before establishing or closing a position. Instead, it’s far more practical to use leading and lagging indicators in conjunction with one another for a more well-balanced approach.
What Are Lagging Indicators?
Lagging indicators are technical indicators which give confirmation signs of a trend after it has developed for a period of time. These indicators are useful because they give signals of a new trend, or confirm an ongoing one, only after it is clear in which direction the price is changing. Lagging indicators are used for identifying already ongoing uptrends and downtrends; this can be helpful in allowing for traders to be more certain of where the price of an ETF may be headed.
The greatest drawback of lagging indicators is their tendency to generate a buy or sell signal after a meaningful move in the price of a security has already occurred. Lagging indicators by nature they are not very practical for alerting traders of potential corrections and trend reversals. These types of indicators will usually generate fewer “false signals” than leading indicators because they are designed to confirm price patterns after they begin to develop.
Examples of lagging indicators include: Simple Moving Average, Exponential Moving Average, and MACD.
What Is A Simple Moving Average?
This is the average price of a security over a specified period of time. A simple moving average is calculated by taking the closing price of an ETF and dividing it by the number of periods you wish to observe. This calculation is then plotted on the price chart of the security and new data points are added as they become available. For a example, a 10-day simple moving average is simply the average price that the ETF has closed at for over the last 10 days.
Simple moving averages cannot be used to predict price direction, instead they simply define the current direction of the trend; this is done by applying a simple arithmetic mean calculation to a collection of historical prices over a specified period of time.
What Is An Exponential Moving Average?
This is similar to a simple moving average except the underlying formula differs by giving more weight to recent prices. An exponential moving average is calculated by starting with a simple moving average and then applying a weighting multiplier. The exponential moving average gives less weight to older prices and more weight to recent prices, which can help to reduce the lag that is common for simple moving averages. Exponential moving averages cannot be used to predict price direction, instead they simply define the current direction of the trend.
How Is A Simple Moving Average Different From An Exponential Moving Average?
The key difference between a simple moving average (SMA) and an exponential moving average (EMA) is the sensitivity to recent price changes. While both moving averages are statistical formulas that aggregate historical closing price data, the underlying difference in their calculations can result in a meaningful difference in certain situations. The exponential moving average is more sensitive to price changes because it gives more weight to recent closing prices, unlike a simple moving average which is a basic arithmetic mean that weights each day’s closing price equally. Consider the chart below.
It’s fairly easy to see how the EMA (green line) is more sensitive to price changes than the SMA (blue line). Notice how when the ETF is trading fairly sideways in the beginning (left) portion of the chart, the EMA and SMA move together almost hand in hand. However, once the price starts to deviate from the trend and turns lower, the EMA is able to reflect this change in direction before the SMA indicates it. The EMA turns negative before the SMA is able to record the downturn in momentum. Likewise, the EMA is also able to detect a positive change in momentum before the SMA reflects it.
Just because the EMA is more sensitive to price changes does not make it any better, or more accurate of a technical indicator, than the SMA. Instead, traders may wish to utilize one of these moving averages over the other in certain scenarios. For example, the simple moving average is more practical when analyzing longer-term trends; this is because each day’s closing price is weighted equally, which results in a clear cut representation for what the average price over a given time period. An exponential moving average on the other hand is more practical when analyzing shorter-term trends; this is because the most recent changes in price receive more weight, which is useful for traders looking to identify the near-term direction of a trend.
Why Is The 200-Day Moving Average Important?
The 200-day moving average is a popular lagging indicator used by traders and investors alike; this technical tool is useful in identifying the prevailing direction of a trend, spotting potential trend reversal points, and also gauging support and resistance levels. The 200-day moving average is by far one of the most widely followed long-term benchmarks; this means that it can be used fairly easily to help you distinguish between uptrends and downtrends over an extended time horizon for any given security.
The 200-day moving average is most commonly based on a simple moving average calculation; this is means that the closing prices of the last 200 trading sessions are summed, then divided by the total time period. This calculation is then plotted on the price chart of the security and new data points are added as they become available.
Like all moving averages, when this indicator is rising, it means that positive price momentum is prevailing. Likewise, when the 200-day moving average is declining, it can be used as a signal that buying pressures are cooling off and momentum is turning negative. As with any technical indicator, the time period you use is extremely important. As such, the 200-day moving average is perhaps most useful when used as a gauge for long-term trends and forecasts; this tool will hold little to no use for more active traders who are looking to capitalize on opportunities over a short-term horizon.
The 200-day moving average can be used to identify uptrends over a long-term horizon. Consider the chart below.
The above example is a daily chart over the course of roughly five years. Notice how the given ETF “bounces” so to speak off the 200-day moving average, the yellow line plotted on the chart; this observation reveals that if a security is trading above its 200-day moving average for an extended period of time, investors can be fairly certain that the given ETF will remain in an uptrend over a long-term horizon. Another important consideration is the fact that the 200-day SMA serves as a support line for securities that are in a clear uptrend. This can be interpreted in a number of ways; first and foremost, investors who are eager to establish a long position in an ETF which is in an uptrend, may wish to wait for a correction down to its 200-day SMA before jumping in. This way the investors can get a better price and also be certain that the ETF will resume its uptrend, assuming it is able to hold above and bounce off its 200-day SMA as it nears it. This simple observation can give traders the necessary conviction they need to enter a long position.
The 200-day moving average can also be used to identify downtrends over a long-term horizon. Consider the chart below.
The above example is a daily chart over the course of roughly three years. Notice how the given ETF “bounces” so to speak off the 200-day moving average, the yellow line plotted on the chart; this observation reveals that if a security is trading below its 200-day moving average for an extended period of time, investors can be fairly certain that the given ETF will remain in a downtrend over a long-term horizon. Another important consideration is the fact that the 200-day SMA serves as a resistance line for securities that are in a clear downtrend. This can be interpreted in a number of ways; first and foremost, investors who are eager to establish a long position in an ETF can easily determine if the given security is attractive by simply noting if it is trading above or below its 200-day moving average. If the security is trading below this line, investors may wish to consider holding off since the given ETF appears to be in a downtrend relative to its longer-term average price. This simple observation can help investors to avoid a potentially sour trade by knowing to avoid securities which have been trading below their 200-day moving average for an extended period of time.
Investors should remember that the 200-day SMA cannot be used to predict price direction, instead it more clearly defines the current direction of the ongoing longer-term trend. Like all simple moving averages, this is purely an arithmetic mean calculation applied over a specified period of time.
What Is A Moving Average Crossover?
This is the instance when a shorter-period moving average crosses either above or below a longer-period moving average. A moving average crossover is a lagging technical indicator because it generates a delayed signal that a trend reversal has occurred. Consider the chart below.
Notice how the moving average crossover occurs several days after the trend reversal itself.
When a shorter-period moving average crosses above a longer-period moving average it is commonly referred to as a “bullish crossover”. A bullish crossover implies that positive momentum is prevailing as the near-term price increases of an ETF outpace the longer-term average price, thus signaling a positive trend reversal. Consider the chart below.
The 10-day SMA (blue line) crossing above the 30-day SMA (green line) gives traders a confirmation signal that the ongoing uprend will likely continue for the foreseeable future.
When are shorter-period moving average crosses below a longer-period moving average it is commonly referred to as a “bearish crossover”. A bearish crossover implies that negative momentum is prevailing as the near-term price decreases of an ETF drag the market price below the longer-term average price, thus signaling a negative trend reversal. Consider the chart below.
The 10-day SMA (blue line) crossing below the 30-day SMA (green line) gives traders a confirmation signal that the ongoing downtrend will likely continue for the foreseeable future.
Why Is A Moving Average Crossover Important?
Moving average crossovers can be treated as lagging technical indicators for confirming trend reversals. This can be a valuable tool when analyzing the price behavior of a security over a long time horizon. By monitoring two different moving averages, ETF traders can get a better understanding of how recent price action relates to the overarching, longer-term trend. Using a short-term moving average helps traders identify the recent momentum in the price, while the long-term moving average serves as a reference point for what the prevailing momentum has historically been.
Suppose a trader has a long position in an ETF which has been in an uptrend for quite some time. If the price drops all of the sudden for a few days, the trader could be faced with a dilemma. The price decrease may prompt the trader to close the position and take profits, in anticipation that the ongoing uptrend is coming to an end. Likewise, the price decrease may prompt the trader to hold onto his position or even increase it, in anticipation that the correction will be temporary and the uptrend will resume. By looking at the market price for an ETF alone it may be difficult to anticipate future movements, while the use of a moving average crossover could help with decision making. Consider the chart below.
Suppose a hypothetical long position in the given ETF at $96 a share. A trader has conviction not to sell his position when the share price drops to $98 a share from $102 a share because the price movement is not significant enough according to the moving averages since there is no crossover. In other words, because the given ETF is in an uptrend, any pullback in price is merely a correction until it become significant enough that short-term momentum brings the market price of the ETF below its longer-term average price. As long as the shorter-term moving average remains above the longer-term moving average, a trader can be confident that the uptrend will continue until there is a meaningful reversal in price momentum which leads to a crossover.
Think of the longer-term moving average, the 30-day SMA (green line) in this example, as a support base. If the shorter-term moving average, the 10-day SMA (blue line) in this example, declines below the longer-term support base, traders should re-evaluate the ongoing uptrend because the recent price action that is forcing the market price below a historical support base could be confirmation of a significant trend reversal.
What Is A Moving Average Crossover Trading Strategy?
This is a popular trading system which generates buy and sell signals based on moving average crossovers. The primary appeal of a moving average crossover trading strategy is the fact that it is purely objective and free of emotions. The first step to this strategy is using two moving averages with different time periods, preferably a short-term one and a long term one. The short-term moving average, a 10-day SMA for example, is used to define the direction of the near-term price momentum. The long-term moving average, a 30-day SMA for example, is used to define the direction of the prevailing trend. By plotting these two moving averages on the price chart of an ETF, traders can get an insightful perspective on the market price as it relates to the bigger trend at hand; the short-term SMA sheds light on how the ETF has been behaving over the past few days, and when used in conjunction with a long-term benchmark, traders can have a better idea of how the prevailing momentum could affect the ongoing trend.
The next step to this strategy is spotting a moving average crossover in a particular ETF you wish to trade. First and foremost, take note of the longer-term trend before you start looking for trading opportunities; distinguishing whether the given ETF is in an uptrend, downtrend, or trading range is absolutely necessary. If the price is stuck in a trading range, then the moving average crossover trading strategy is a less than ideal approach to profiting from this ETF. This strategy tends to work best when the given ETF is in a well-defined trend. Consider the chart below.
Suppose you observe this ETF for a period of time before deciding to establish a position. Notice the steady uptrend; this simple observation should prompt the trader to start looking for buying opportunities and establish a long position given that the prevailing price momentum is positive. After observing the ETF’s price behavior for a period of time, the trader should then take note of how the price behaves after a moving average crossover occurs. Considering the example above, we can see that during an uptrend the bearish crossover signals generated tend to be “false” trend reversal signals. Instead, the trader can wait for a bearish crossover and use that as a heads up to be on the lookout for buying opportunities. The trader can then wait for a bullish crossover and use that as a buy signal. After a long position has been established, the trader must then look for an exit signal and ideally lock-in profits.
Moving along the graph to the right of the yellow “BUY” signal, we can see that the 10-day SMA remains steadily above the 30-day SMA; this implies the uptrend is strong because near-term price momentum is steadily driving the market price above its longer-term average price. Given that price of the ETF has now risen well above the buy price, the trader may wish to exercise disciplined profit-taking and treat the next sell signal as a real one. By doing so, the trader will sell his position once the bearish crossover occurs; when the 10-day SMA crosses below the 30-day SMA the trader can expect for downward momentum to continue until the prices nears a support level or momentum reverses again. It’s important to remember that because moving averages are lagging technical indicators, this trading strategy will generate late buy and sell signal by nature.
What Is An Oscillator?
This is a type of technical analysis tool that is most applicable in situations when the underlying security is not necessarily in a trend, but rather its price moves back-and-forth within a trading channel or trading range. Unlike moving averages, which tend to be more useful for technical analysis when an ETF is in a definite trend, oscillators can be valuable technical indicators for when the direction of prevailing momentum is difficult to determine over a longer period of time. An oscillator is a statistical calculation that finds two price extremes and alerts traders when the ETF is deemed to be “overbought” or “oversold”. Because an oscillator moves between two extreme values, buy and sell signals are generated accordingly as the market price approaches each respective boundary. Oscillator indicators will generate buy signals when the price of an ETF is deemed to be “oversold”, and sell signals when the price appears to be “overbought”.
Examples of popular technical indicators which are oscillators include: Relative Strength Index, Stochastic Oscillator, Williams %R, and Ultimate Oscillator.
What Is The Ultimate Oscillator?
This is a popular oscillator which can be used as a leading technical indicator for price momentum. The ultimate oscillator is designed to be just what its name suggests; this unique indicator strives to avoid pitfalls common across other oscillator indicators by comparing price movements over three different time periods instead of just one. By incorporating three time periods into the calculations, the ultimate oscillator can be expected to produce fewer false signals than indicators like RSI or Williams %R for example, seeing as how these two are based a one time period.
An ultimate oscillator reading should be interpreted with the specified time period in mind; traditionally, the ultimate oscillator will be based on price action over the last 7-day, 14-day, and 28-day periods.
When the ultimate oscillator is increasing, it implies that positive price momentum is prevailing and buying pressures are driving the price of the given ETF higher. Likewise, when the ultimate oscillator turns lower, it implies that selling pressures are the dominant force for the time being.
This indicator oscillates between 0 and 100; traditionally, the ultimate oscillator is considered to be in “overbought” territory when the indicator is above 70 and in “oversold” territory when the indicator is below 30. For a more conservative interpretation of this indicator, traders may wish to adjust their overbought and oversold levels farther apart, at 80 and 20 respectively for example.
What Is A Stochastic Oscillator?
This is a popular leading technical indicator that is used to gauge the price momentum of a security over a specified period of time. The stochastic oscillator works by comparing the closing price of an ETF relative to the price range over a specified period of time. By doing so, the stochastic oscillator can be used to identify when an ETF is potentially “overbought” or “oversold”.
A stochastic oscillator reading should be interpreted with the specified time period in mind; for example, a 10-day stochastic reading is based on the relative change of price movements over the last 10 trading sessions.
When the stochastic oscillator is increasing, it implies that positive price momentum is prevailing and buying pressures are driving the price of the given ETF higher. Likewise, when the stochastic oscillator turns lower, it implies that selling pressures are the dominant force for the time being.
This indicator oscillates between 0 and 100; traditionally, the stochastic oscillator is considered to be in “overbought” territory when the indicator is above 80 and in “oversold” territory when the indicator is below 20.
What Does It Mean When An ETF Is Overbought?
This is the instance when an oscillator indicator has reached its upper extreme level and the price of the underlying security is deemed to be unjustifiably high. Oversold is the opposite of overbought. An overbought signal, commonly treated as a sell signal, implies that a correction or negative trend reversal may soon develop because the price has appreciated to such a degree that selling pressures are likely to follow as traders start to take profits. Overbought signals should not be treated as perfectly accurate indicators because they are based on a statistical calculation after all.
From a fundamental perspective, the term overbought is used to describe the instance when the price of a security has appreciated to such a degree that the underlying fundamental factors do not truly justify such a drastic change in valuation.
What Does It Mean When An ETF Is Oversold?
This is the instance when an oscillator indicator has reached its lower extreme level and the price of the underlying security is deemed to be unjustifiably low. Overbought is the opposite of oversold. An oversold signal, commonly treated as a buy signal, implies that a rally or positive trend reversal may soon develop because the price has depreciated to such a degree that buying pressures are likely to follow as traders look for opportunities. Oversold signals should not be treated as perfectly accurate indicators because they are based on a statistical calculation after all.
From a fundamental perspective, the term oversold is used to describe the instance when the price of a security has depreciated to such a degree that the underlying fundamental factors do not truly justify such a drastic change in valuation.
What Is Relative Strength Index (RSI)?
This is a popular leading technical indicator that functions as an oscillator. RSI works by comparing the relative change of price movements, in relation to recent gains and recent losses. This indicator looks at the number of positive days relative to the number of negative days for a given ETF over a specified period of time.
An RSI reading should be interpreted with the specified time period in mind; for example, a 10-day RSI reading is based on the relative change of price movements over the last 10 trading sessions.
When the RSI is increasing, it implies that positive price momentum is prevailing and buying pressures are driving the price of the given ETF higher. Likewise, when RSI turns lower, it implies that selling pressures are the dominant force for the time being.
The RSI indicator oscillates between 0 and 100; traditionally, RSI is considered to be in “overbought” territory when the indicator is above 70 and in “oversold” territory when the indicator is below 30. For a more conservative interpretation of this indicator, traders may wish to adjust their overbought and oversold levels farther apart, at 80 and 20 respectively for example.
What Is Moving Average Convergence Divergence (MACD)?
This is a popular lagging technical indicator that works by combining two exponential moving averages with different time period. MACD is a unique tool because it applies an oscillator calculation to compare short-term momentum versus the longer-term momentum of a given ETF. In essence, this is a momentum indicator that is inherently lagging in nature because it is based on exponential moving average calculations.
MACD is also different from other oscillator indicators because it is unbounded; this means that “overbought” and “oversold” territories do not appear in the traditional sense. Instead, the MACD indicator moves can rise or fall below a zero line as the moving averages are plotted.
When the MACD indicator is above the zero line, it implies that positive price momentum is prevailing and buying pressures are driving the price of the given ETF higher. Likewise, when the MACD turns below the zero line, it implies that selling pressures are the dominant force for the time being.
What Is Williams % R?
This is a popular leading technical indicator that functions as an oscillator. Williams %R works by comparing the closing price of an ETF relative to the price range over a specified period of time. By doing so, Williams %R can be used to identify when an ETF is potentially “overbought” or “oversold”.
A Williams %R reading should be interpreted with the specified time range in mind; for example, a Williams %R 10-day reading is based on the relative change of price movements over the last 10 trading sessions.
When the Williams %R is increasing, it implies that positive price momentum is prevailing and buying pressures are driving the price of the given ETF higher. Likewise, when the Williams %R turns lower, it implies that selling pressures are the dominant force for the time being.
The Williams %R indicator oscillates between 0 and 100; traditionally, Williams %R is considered to be in “overbought” territory when the indicator is above 80 and in “oversold” territory when the indicator is below 20.
What Is A Fibonacci Retracement?
This is a popular technical analysis tool used by traders to identify potential support and resistance levels. Unlike moving averages and oscillators which consider factors such as price and time, this tool is based entirely on a mathematical ratio. The underlying Fibonacci sequence is well known amongst mathematicians, scientists, and technical traders alike; the sequence, originally developed by Leonardo Fibonacci (around 1200 AD), is derived by summing the two preceding terms in a series (1, 1, 2, 3, 5, 8, 13, 21, etc.). On its own, this string of numbers bears no significance, however, the quotient of its adjacent terms signify a meaningful proportion (roughly 1.618) which corresponds to numerous relationships in nature as well as patterns in stock charts. The golden ratio, 1.618 (and its inverse .618), is important to technical traders because it is the underlying proportion used to project likely support and resistance levels.
How Are Fibonacci Retracements Useful For ETF Trading?
The Fibonacci Retracement can be used to idenfity potential support and resistance levels; as such, this technical analysis tool can assist traders in helping them set entry points before establishing either long or short positions as well as potential price targets. This incredibly versatile tool can be applied in uptrends as well as downtrends; furthermore, it can be applied over any sort of time horizon, making it useful for all breeds of traders.
The Fibonacci Retracement is based on multiples of the golden ratio with the most common ones being: 23.6%, 38.2%, and 61.8%. The above mentioned multiples are translated into projected support price levels when a Fibonacci Retracement is applied to an uptrend; the starting point is the lowest point of the trend, and the ending point is the peak of the trend. See chart below (Fibonacci Retracement in blue).
Notice how the given ETF falls back to support at the 61.8% level after peaking just below $130 a share. Traders can use the Fibonacci Retracement to project likely support levels for a given ETF which is an uptrend. These support levels are not always accurate; instead, the Fibonacci Retracement is useful in gauging general price levels of where an ETF could potentially find support.
The Fibonacci Retracement multiples mentioned above are translated into projected resistance price levels when a Fibonacci Retracement is applied to a downtrend, which is done by drawing it in reverse; the start point is the highest point of the trend, and the ending point is the where the price temporarily reverses upwards. See chart below (Fibonacci Retracement in blue).
Notice how the given ETF rises back to resistance at the 61.8% level before resuming its ongoing dowtrned. When drawn in reverse, traders can use the Fibonacci Retracement to project likely resistance levels for a given ETF which is in a downtrend. These resistance levels are not always accurate; instead, the Fibonacci Retracement is useful in gauging general price levels of where an ETF could potentially peak before turning lower again.
Like all technical analysis tools, traders should not rely on any one Fibonacci Retracemenet as their only source of conviction before establishing a position. Instead, it is recommended to combine this tool in conjunction with other indicators to make for a more wholesome technical analysis of a given ETF.
What Is Volatility?
This is the term used to describe the variation of price of a financial security. Volatility is a mathematical calculation that is designed to measure the dispersion of returns, for a specified time period, for virtually any security or financial asset. While volatility can be measured in a number of ways, this metric is generally used as a gauge for judging how “risky” a given security is over a specified period of time.
Because volatility measures the variation of price, a higher volatility reading implies more uncertainty; this is because a higher volatility simply means that the returns on a given investment are more likely to be spread out all over the place, thus making it “riskier” over time. Likewise, a lower volatility reading implies that the price of a given security is not likely to spike up or drop down dramatically; a lower volatility reading implies that the expected returns on a given investment are more likely to be consistent, thus making it “safer” over time.
As with any financial metric or technical indicator, volatility should not be used as the sole factor in determining whether or not a given ETF suits your objectives and risk preferences.
What Is The Difference Between 5-Day Volatility And 200-Day Volatility?
The inherent difference between a 5-day volatility and a 200-day volatility reading is the time period used in the underlying mathematical calculation. Because volatility measures the dispersion in returns for a given security over a specified period of time, the 5-day calculation is useful in gauging the potential uncertainty for a given investment over a relatively short period of time. Likewise, using the 200-day volatility reading to gauge the potential uncertainty for a given investment over a relatively long period of time is more appropriate than say a 5-day or 20-day volatility reading for example.
Keep in mind that a 5-day volatility reading is essentially a snapshot of recent trading activity over the course of a single week. As such, this metric can often times give “skewed” representations of what the expected volatility of a given security actually is over a long-term investment horizon.
For example, consider a historically stable financial security that has a spike in price over the course of a day or two. Someone who is judging the relative risk between potential investments based on a 5-day volatility reading will come to inherently inaccurate conclusions regarding the expected levels of volatility for the given security. Instead, investors are better off relying on a long-term measure of volatility, such as the 200-day reading; this calculation serves to provide a more accurate gauge of the potential volatility associated with a given security over the long haul.
What Does Volatility Mean For ETF Traders?
For experienced ETF traders, volatile market environments are abundant with opportunities; on the other hand, for most traders and investors alike, volatility is generally perceived as a negative element in financial markets. Volatility often carries a negative connotation in the financial world because it is used interchangeably with terms like risk and uncertainty. As such, higher volatility implies more risk and uncertainty, which is logically seen as a detriment for most people.
Financial markets are said to be volatile when prices for securities across the board fluctuate drastically either up or down. ETF traders who are looking to take advantage of mispricings are usually prone to do so when markets are deemed to be volatile; this is because in times of panic selling or euphoric buying on Wall Street, the more inexperienced traders are likely to make mistakes as they are swayed by media headlines and personal emotions.
Volatility in itself is neither good nor bad, the way we choose to interpret this calculation as it relates to our investment situation is what matters. Remember that volatility is both a source of risk as well as return; greater uncertainty can mean steeper-than-expected losses as well as greater-than-expected profits. When thinking about volatility as it relates to your ETF trading experience, it’s important to keep in mind that this is purely a mathematical calculation, and as such, it provides a backward-looking representation of the historical price behavior of a given security.
Novice traders may wish to limit their scope to ETFs with a 200-day volatility reading below a specified level in an effort to avoid financial instruments which have a tendency to generate relatively unstable returns. On the other hand, more experienced traders may wish to focus on ETFs with relatively higher volatility readings as this translates into greater profit potential.
When comparing the volatility readings between different ETFs, don’t forget one of the golden rules on Wall Street: past performance is not a guarantee of future returns. Volatility can be a useful metric to consider when comparing similar ETFs, however, this should not be the sole factor you rely on to make investment decisions for the simple reason that historical performance data cannot reliably predict future price action.
Related: Dow Jones Industrial Average (INDEXDJX:.DJI), S&P 500 Index (INDEXSP:.INX), SPDR S&P 500 ETF (NYSEARCA:SPY), Nasdaq Composite (INDEXNASDAQ:.IXIC), Russell 2000 Index (INDEXRUSSELL:RUT).
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