An introduction to pairs trading with ETFs

Tutorial: Introduction to exchange-traded funds

As a hedging strategy, the goal is to have gains from one side of the transaction offset the losses of the other. Although most people use individual stocks in pairs trading, the technique can also work well with exchange-traded funds (ETFs) that cover a particular sector or a broad market index. Here we look at ETF pairs trades and provide historical examples where they would have created a profit for a savvy pairs trader. (To learn more, see ETFs: How did we live without them? and how to use ETFs in your portfolio.)

Intra-sector ETF pairs trade
ETFs have become increasingly popular over the years, and several ETFs are often available in a given sector. Although ETFs in the same sector may have similar names, they are often very different from one another, both in terms of the stocks they invest in and their investment returns.

One of the most popular investment themes is the emerging markets, particularly interest in China. Two major ETFs that invest specifically in Chinese stocks include the iShares FTSE/Xinhua China 25 ETF (PSE: FXI) and the PowerShares Golden Dragon Halter China ETF (AMEX: PGJ). As an example of a possible pairs trade here at investor who believes in China as a solid investment, but at the believes the Chinese same time the market may be faltering, could go long on FXI and short PGJ based on the holdings and strategies of the respective ETFs. (Keep reading about emerging markets in the new world of emerging market currencies and Broadening the borders of your portfolio.)

Intra-sector pairs trades such as this one are the least popular type of trade. While ETFs in the same sector might experience dissimilar performance over a given period, the opportunities for success are limited because the difference is likely to be narrower than it would be for pairs trades that use ETFs from different sectors.

Inter sector ETF pairs trade
Instead of focusing on ETFs that invest in the same sector, this strategy matches different ones to create a true portfolio hedge. To do this, an investor would be long the sector or sectors that have the best outlook and short the sectors that could be vulnerable to a downturn. (Want to know more about pairs trades?) (Check profit in pairs finding out.)

The strategy makes sense since individual sectors can perform quite differently from each other and from the market as a whole. For example, during the first 4.5 months of 2008 the S & P 500 index was down 3% for the year. During that same time period, the best-performing ETFs all focused on the energy sector, with PowerShares DB energy ETF (AMEX: DBE) up 36%, and the leading performers, the United States natural gas ETF (AMEX: UNG), up 51%.

At inter-sector ETF pairs trade would have proved useful in October 2007, when the stock market reached a new high, and the fears of a possible credit crunch in the U.S. began to hit the headlines. The finance sector appeared shaky, because credit issues have a direct impact on banks and other financial institutions. The Fed was on the verge of lowering interest rates several times and the stock market appeared poised for a correction. An investor who was concerned about the market, but who did not want to unload his stocks, could have bought the iShares Utilities ETF (PSE: IDU) because the utilities sector has historically outperformed in rough times. To hedge the long play on IDUS, the short side could have been the vanguard Financials ETF (AMEX: VFH), which represented a sector that appeared vulnerable.

From October through the middle of May 2008, IDUS lost 1% and VFH fell 24%. The hedge was not perfect because IDUS did not move higher, but shorting the finance sector ETF made the trade very profitable. The net gain of 23% what much better loss than the 9% of the S & P 500 in the same time frame.

Index ETFs pairs trade
From year to year, money flows in and out of the varying asset classes. Initially, the trend of the early 2000s the small-cap stocks involved beating the large caps. From 2000 through 2007, the Russell 2000, a small-cap index gained 52%, while the Dow Jones industrial average gained only 14%. Typically, one asset class does not stay on top for more than a few years before falling to the bottom as the investing cycle progresses. Investors who want to play the future flow of money between asset classes can exploit this pattern with index ETF pairs trading.

In 2007, for example, money was coming out of the small-cap stocks and moving into the large cap asset class for the first time in years. Investors seeking to remain in the market but wishing to hedge a long position could have gone long the diamonds ETF (AMEX: DIA), which tracks the large-cap Dow Jones industrial average, and short the iShares Russell 2000 ETF (PSE: IWM), which tracks small cap stocks. In 2007, DIA gained 6.5% and IWM lost 2.7%, resulting in a net gain of 9.2% on the position. (Keep reading on this subject in understanding cycles - the key to market timing and sector rotation: the essentials.)

Timing an ETF pairs trade
Although the timing of any pairs trade is critical, the hedging aspect of the strategy lowers the risk of mis timing the trade. If an investor does not feel completely certain about a new long ETF position, it may be prudent to hedge it with a sector or index ETF that might lower the risk of the trade without removing all of the reward.

For those with a good understanding of market volatility, pairs trading can be a profitable way to take advantage of it.

by Matthew McCall (Contact author |) (Biography)

Matthew McCall is the president of Penn financial group, LLC, a registered investment advisor. He also publishes two newsletters, the ETF bulletin and the PFG letter as well as other educational material. As a registered investment advisor, he manage clients' investments based on their specific goals and objectives.

Rate this article:  Your rating: overall rating: vote now! The security that offers the best protection against purchasing power risk or inflation is which of the following? (view answer)A formula timing plan which consists of periodic purchases of a fixed dollar amount of an investment company regardless of price is known as: (view answer) is there a buy-and-hold strategy in forex, or is the only way to make money by trading? (view answer)How do you lose money in the Forex market? (view answer)What's the difference between weighted average accounting and FIFO / LILO accounting methods? (view answer)What effect did the bankruptcy abuse prevention and Consumer Protection Act of 2005 have on debtors? (view answer)

How to build a trading indicator

TUTORIAL: Technical Analysis

Background
Recall that the theory behind technical analysis states that financial charts take all things into account - that is, all fundamental and environmental factors. The theory goes on to state that these charts display elements of psychology that can be interpreted via technical indicators.

To better understand this, let's look at an example. Fibonacci retracements are derived from a mathematical sequence: 1, 1, 2, 3, 5, 8, 13 and so on. We can see that the current number is the sum of the previous two numbers. What does this have to do with the markets? Well, it turns out that these retracement levels (33%, 50%, 66%) influence traders' decisions to such an extent that the levels have become a set of psychological support and resistance levels. The idea is that, by finding these points on charts, one can predict the future directions of price movements. (For more on these handy numbers, check out Taking The Magic Out Of Fibonacci Numbers.)

Components of an Indicator
All indicators are created to predict where a price is headed when a certain condition is present. Traders try to predict two basic things: Support and resistance levels - These are important because they are the areas at which prices reverse direction. Time - This is important because you need to be able to predict when price movements will occur.

Occasionally, indicators predict these two factors directly - as is the case with Bollinger Bands or Elliott's waves - but indicators commonly have a set of rules enacted in order to issue a prediction. (For more basics, check out Support & Resistance Basics.)

For example, when using the breadth thrust indicator (which is represented by a line indicating momentum levels), we need to know which levels are relevant. The indicator itself is simply a line. The breadth thrust indicator looks similar to RSI, in that it is "range-bound," and it is used to gauge the momentum of price movements. When the line is in the median zone, there is little momentum. When it rises into the upper zone, we know that there is increased momentum, and vice versa. One could look to take a long position when the momentum is on the rise from low levels and look to short after the momentum peaks at a high level. It is important to set rules to interpret the meaning of an indicator's movements in order to make them useful.

With this in mind, let's look at ways of creating predictions. There are two main types of indicators: unique indicators and hybrid indicators. Unique indicators can be developed only with core elements of chart analysis, while hybrid indicators can use a combination of core elements and existing indicators.

Components of Unique Indicators
Unique indicators are based on inherent aspects of charts and mathematical functions. Here are two of the most common components:

1. Patterns
Patterns are simply repeating price sequences apparent over the course of a given time period. Many indicators use patterns to represent probable future price movements. For example, Elliott Wave theory is based on the premise that all prices move in a certain pattern that is simplified in the following example:

 Figure 1: An Elliott wave pattern
There are many other simple patterns that traders use to identify areas of price movement within cycles. Some of these include triangles, wedges and rectangles. 

These types of patterns can be identified within charts simply by looking at them; however, computers offer a much faster way to accomplish this task. Computer applications and services provide the ability to locate automatically such patterns.

2. Mathematical Functions
Mathematical functions can range from price averaging to more complex functions based on volume and other measures. For example, Bollinger Bands are simply fixed percentages above and below a moving average. This mathematical function gives a clear price channel showing support and resistance levels

Components of Hybrid Indicators
Hybrid indicators use a combination of existing indicators and can be thought of as simplistic trading systems. There are countless ways in which elements can be combined to form valid indicators. Here's an example of the MA crossover:

This hybrid indicator utilizes several different indicators including three instances of the moving averages. One must first draw the 3, 7 and 20-day moving averages based on the price history. The rule then looks for a crossover in order to buy the security or a cross-under in order to sell. This system indicates a level at which price movement can be expected, and provides a reasonable way to estimate when this will occur (as the lines draw closer together). Here's what it might look like:

 Figure 1: A moving average crossover
Creating an Indicator
A trader can create an indicator by following several simple steps:
Determine the type of indicator you wish to build: unique or hybrid. Determine the components to be included in your indicator. Create a set of rules (if necessary) to govern when and where price movements should be expected to occur. Test your indicator in the real market through back testing or paper trading. If it produces good returns, put it into use. An Example
Suppose we want to create an indicator that measures one of the most basic elements of the markets: price swings. The goal of our indicator is to predict future price movements based on this swing pattern. (For related reading, check out Using Technical Indicators To Develop Trading Strategies.)

Step 1
We look to develop a unique indicator using two core elements, a pattern and math functions.

Step 2
Looking at weekly charts of company XYZ's stock, we notice some basic swings between bullishness and bearishness that each last about five days. As our indicator is to measure price swings, we should be interested in patterns to define the "swing" and a mathematical function, price averages, to define the scope of these swings.

Step 3
Now we need to define the rules that govern these elements. The patterns are the easiest to define: they are simply bullish and bearish patterns that alternate every five or so days. To create an average, we take a sample of the duration of upward trends and a sample of the duration of downward trends. Our end result should be an expected time period for these moves to occur.

To define the scope of the swings, we use a relative high and a relative low, and we set these at the high and low of the weekly chart. Next, to create a projection of the current incline/decline based on past inclines/declines, we simply average the total inclines/declines and predict the same measured moves (+/-) occur in the future. The direction and duration of the move, again, is determined by the pattern.

Step 4
We take this strategy and test it manually, or use software to plot it and create signals. We find that it can successfully return 5% per swing (every five days). (Find out more in Backtesting And Forward Testing: The Importance Of Correlation.) 

Step 5
Finally, we go live with this concept and trade with real money. 

Bottom Line 
Building your own indicator involves taking a deeper look into technical analysis, and then developing these basic components into something unique. Ultimately, the aim is to gain an edge over other traders. Just look at Ralph Nelson Elliott or W.D. Gann; their successful indicators gave them not only a trading edge but also popularity and notoriety within financial circles worldwide.  

by Justin Kuepper (Contact Author | Biography)

Justin Kuepper has many years of experience in the market as an active trader and a personal retirement accounts manager. He spent a few years independently building and managing financial portals before obtaining his current position with Accelerized New Media, owner of SECFilings.com, ExecutiveDisclosure.com and other popular financial portals. Kuepper continues to write on a freelance basis, covering both finance and technology topics.

Introduction to types of trading: fundamental traders

TUTORIAL: Investing 101

Reviewing Different Types of Traders
Before we focus on fundamental trading, let's review all the major styles of equity trading: Scalping - The scalper is an individual who makes dozens or hundreds of trades per day, trying to "scalp" a small profit from each trade by exploiting the bid-ask spread. (You can read about scalping in Introduction to Types of Trading: Scalpers.)
Momentum Trading - Momentum traders look to find stocks that are moving significantly in one direction on high volume and try to jump on board to ride the momentum train to a desired profit. 
Technical Trading - Technical traders are obsessed with charts and graphs, watching lines on stock or index graphs for signs of convergence or divergence that might indicate buy or sell signals. 
Fundamental Trading - Fundamentalists trade companies based on fundamental analysis, which examines things like corporate events such as actual or anticipated earnings reports, stock splits, reorganizations or acquisitions.
Swing Trading - Swing traders are really fundamental traders who hold their positions longer than a single day. Most fundamentalists are actually swing traders since changes in corporate fundamentals generally require several days or even weeks to produce a price movement sufficient enough for the trader to claim a reasonable profit. 

Novice traders might experiment with each of these techniques, but they should ultimately settle on a single niche, matching their investing knowledge and experience with a style to which they feel they can devote further research, education and practice. (You can read about technical trading in Introduction to Types of Trading: Technical Traders.)

Let's begin our exploration of fundamental trading.

Fundamental Data
Most equity investors are aware of the most common financial data used in fundamental analysis: earnings per share, revenue and cash flow. These quantitative factors can include any figures found on a company's earnings report, cash-flow statement or balance sheet; these factors can also include the results of financial ratios such as return on equity and debt to equity. Fundamental traders may use such quantitative data to identify trading opportunities if, for example, a company issues earnings results that catch the market by surprise.

Two of the most closely watched fundamental factors for traders and investors everywhere are earnings announcements and analyst upgrades and downgrades. Gaining an edge on such information, however, is very difficult since there are literally millions of eyes on Wall Street looking for that very same edge.

Earnings Announcements
The most important situation surrounding earnings announcements is the pre-announcement phase, the time in which a company issues a statement stating whether it will meet, exceed, or fail to meet earnings expectations. A trader will want to trade immediately after such an announcement because a short-term momentum opportunity will likely be available.

Analyst Upgrades and Downgrades
Similarly, analyst upgrades and downgrades may present a short-term trading opportunity, particularly when a prominent analyst unexpectedly downgrades a stock. The price action in this situation can be similar to a rock dropping from a cliff, so the trader must be quick and nimble on his short-selling buttons.

Earnings announcements and analyst ratings are actually closely associated with momentum trading, which keeps alert to unexpected events that cause a stock to trade a large volume of shares and move steadily either up or down.

The fundamental trader is often more concerned with gaining an edge on information about speculative events that the rest of the market may lack. To stay one step ahead of the market, astute traders can often use their knowledge of historical trading patterns that occur during the advent of stock splits, acquisitions, takeovers and reorganizations.

Stock Splits
When a $20 stock splits 2-for-1, the company's market capitalization does not change, but the company now has double the number of shares outstanding, each at a $10 stock price. Many investors believe that, since investors will be more inclined to purchase a $10 stock than they would a $20 stock, a stock split will soon increase the company's market capitalization, (but remember that this fundamentally doesn't change the value of the company).

To trade successfully on stock splits, a trader must, above all, correctly identify the phase at which the stock is currently trading. Indeed, history has proven that a number of specific trading patterns occur before and after a split announcement: price appreciation and therefore short-term buying opportunities will generally occur in the pre-announcement phase and the pre-split run-up; and price depreciation (shorting opportunities) will occur in the post-announcement depression and post-split depression. By identifying these four phases correctly, a split trader can actually trade in and out of the same stock at least four separate times before and after the split, with perhaps many more intra-day or even
hour-by-hour trades.

Acquisitions, Takeovers and Reorganizations
The old adage "buy on rumor, sell on news", applies to trading on acquisitions, takeovers and reorganizations. In these cases, a stock will often experience extreme price increases in the speculation phase leading up to the event and significant declines immediately after the event is announced.

That said, the old investor's adage "sell on news" needs to be qualified significantly for the astute trader. A trader's game is to be one step ahead of the market, so he or she is very unlikely to buy a stock in a speculative phase and hold it all the way to the actual announcement. The trader is concerned about capturing some of the momentum in the speculative phase, and may trade in and out of the same stock several times as the rumor mongers work their magic. He may hold a long position in the morning and short in the afternoon, being ever watchful of charts and Level 2 data for signs of when he or she should change position.

And when the actual announcement is made, he or she will likely have an entirely different trading opportunity: the trader will likely short the stock of an acquiring company immediately after it issues news of its intent to acquire and thereby ending the speculative euphoria leading up to the announcement. Rarely is an acquisition announcement seen positively, so shorting a company that is doing the acquiring is a doubly sound strategy.

By contrast, a corporate reorganization may very well be viewed positively if the market had not been expecting it, and if the stock had already been on a long-term slide due to internal corporate troubles. If a board of directors suddenly ousts an unpopular CEO, for example, a stock may very well exhibit short-term upward movement in celebration of the news.

Trading the stock of a takeover target presents a special case since a takeover offer will have a price per share associated with it. A trader has to be careful to avoid getting stuck holding stock at or near the offer price because the stock will generally not move significantly in the short-term once it finds its narrow range near the target. Particularly in the case of a rumored takeover, the best trading opportunities will be in the speculative phase, the time in which a rumored price per share for the takeover offer will drive actual price movement.

Rumor and speculation are risky trading propositions, especially in the cases of acquisitions, takeovers and reorganizations - such events may spawn extreme stock-price volatility. Because, however, of the potential for rapid price movements, these events also potentially serve as the most lucrative fundamental-trading opportunities available. (You can read about swing trading in Introduction to Types of Trading: Swing Traders.)

Conclusion
Many trading strategists have developed rather sophisticated models of trading opportunities associated with events leading up to and following earnings announcements, analyst upgrades and downgrades, stock splits, acquisitions, takeovers and reorganizations. These charts resemble the charts used in technical analysis, but lack the mathematical sophistication. The charts are simple pattern charts. They display historical patterns of trading behaviors that occur close to these events, and these patterns are used as guides for making a prediction about short-term movement in the present.

If fundamental traders are able to correctly identify the current position of stocks and subsequent price movements that are likely to occur, they stand a very good chance of executing successful trades. Trading on fundamentals may be risky in cases of euphoria and hype, but the astute trader is able to mitigate risk by making history his or her guide to short-term trading profits. In short, do your homework before jumping in.

by Jason Van Bergen (Contact Author | Biography)

Money management matters in futures trading

TUTORIAL: Technical Analysis

Practicing Discipline
Money management may be the most overlooked area of trading. The subject is often overlooked because it is misunderstood, and frankly, it sounds boring compared to a discussion of stochastics or technical analysis. However, it is critical to any successful trading plan.

Even a trading plan as simple as a moving average crossover system can be a net winner when money management is applied. This discussion of money management will build a foundation of concepts that can be applied to any trading plan.

A money management plan will help you in another key area - discipline. Many investors don't hesitate to enter an investment, but then they are at a loss as to what they should do next. Having a money management plan will keep investors disciplined and prevent the balance of emotions, fear and greed, from getting out of sync. (For related reading, see Having A Plan: The Basis Of Success.)

Starting From Square One
A good place to begin when considering money management is the concept of risk control. Traders are attracted to futures because of the leverage that is provided - vast sums can be won on very little invested capital. However, the cost of that leverage is the fact that you can lose more than the balance of your account. So, how can you control that risk? (For more insight, see Tutorial: Futures Fundamentals.)

First, consider that the rules regarding margin are about minimums. There are no rules that affect the maximum margin you can apply to a trade. In other words, if you are concerned with the leverage of potential losses of a market, apply more capital. True, you will be reducing your overall return, but this also brings everything into balance. (To read more about this topic, see the Margin Trading tutorial.)

Example: If corn is trading at $3 per bushel and a contract is 5,000 bushels, then the full contract value of a single contract of corn is $15,000. The exchange generally requires a minimum margin of around 5-7%, which would be between $750 and $1,050. This is the minimum.

If our trading plan requires that we risk a $0.10 move in corn, we are risking $500, or around 48-66% of our investment. However, if half the contract value were applied to the trade, or $7,500, that same $0.10 move would account for only 6.6% of our invested capital. That's quite a difference. Increase that to investing the full contract value and a trader on the long side (buy) removes the possibility of losing more than the initial investment.

Plan Your Trading Risk
So what is the right amount to risk on a trade? There is no hard and fast rule on this, but account size, risk tolerance, financial objectives and how it fits the total trading plan should all be taken into account. You can see from the example above that there is quite a range. Conservative traders generally risk around 5-7% on a given trade, but this also requires either a larger amount of capital or precise entry and exit points. Increasing that to a 12% risk allows for taking on a little more leverage and wider market swings. More than that amount isn't necessarily wrong - it just depends on other factors of your plan. However, if you're taking on bigger risks, you must also consider whether your profit objective is realistic.

Consider this mathematical anecdote while you think about where your risk tolerance fits in to the above discussion. If you take a 50% loss on a trade, you need to achieve a 100% return to get it back. For example, if you own 100 shares of a stock at $50 per share and it loses 50%, your $5,000 will drop to $2500. You must now achieve a 100% return to get back to $5,000. Thinking about risk in this way can put your risk tolerance back into perspective!

Stop Runaway Trading Losses
The importance of the stop-loss order as part of money management cannot be overlooked. A predetermined stop keeps a trader disciplined in executing his or her money management. However, many traders don't understand the "how" of stop placement. Stops cannot be placed arbitrarily - careful consideration must go into where to set a stop. (To learn more, read The Stop-Loss Order - Make Sure You Use It, The Basics Of Order Entry and Limiting Losses.)

Traders sometimes set arbitrary stops, but is generally a bad idea. This is when a trader says, "I am placing my stop at a risk of $500 per trade because that is what I am comfortable losing on a trade - no more." Let's assume that this trader employs a system of technical analysis and swing trading. The swing low of the market in question is a move of $750. Does this trader's $500 stop make sense? Absolutely not! Moreover, it is probably as close to a guaranteed loss as you can get. What if the swing low was a $250 move? The $500 risk still doesn't make sense because it is too much risk.

The key to keep in mind when you're setting your stops is that the stop price must fit the market. If the required risk on a trade is too much for the trader's risk tolerance or account size, then the trader should find a market that fits. It is foolish to trade a market with too little capital. There is an old saying that warns against bringing a knife to a gun fight. Likewise, if you come to a market with too little capital, you may as well save everyone a lot of time and cut a check for the trade's counterparty right then and there.

Bottom Line
Make sure the markets that you are trading in fit with your account size and risk tolerance. Make sure the percentage you are willing to risk per trade fits the plan and the market. And remember that none of these components exists in a vacuum. Focus on one without the other and you are headed for trouble. Weigh these factors together and you will be putting yourself on the track to building a successful trading plan.

by Chad Butler,Senior Market Strategist, RJO Futures (Contact Author | Biography)

Chad Butler is a senior market strategist with RJOFutures, a division of R.J. O'Brien. His experience includes option spread trading, diversified trend following and the development of a number of index arbitrage programs. Chad's published work appears in McGraw-Hill's "Complete Guide to Single Stock Futures", SFO Magazine and other trade publications. He currently writes for various commodities newsletters and has been a featured seminar speaker teaching his various trading techniques to audiences large and small.

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