where you learn new ways to understand the latest market trends, gain strategy insights, and learn from the experts. My name is Rod Mahnami and I’m grateful that you’ve given me this opportunity to join you on your investment journey.
At Profit effect we know that the only “secret” to successful investing is well-informed investors applying sound market strategies. That’s why the Profit effect mission is to teach you how to understand the market, the modern tools available for successful investing, and how to apply both for investment success.
In this edition of Profit Talk we’re going cover one of my favorite investment products available to today’s investor, called Exchange Traded Funds, often referred to by the acronym ETF. I will also share with you a technique that can be used to quickly screen 1000’s of stocks in an instant to find prospective trade or investment candidates.
An exchange traded fund or ETF is a marketable security, like stock, which owns the underlying assets and divides the ownership of the assets into shares. The assets include shares of stock such as an index, or bonds, commodity futures, precious metals and currencies. Unlike mutual funds, ETFs trade just like stocks and typically have much better liquidity or trading volume and lower fees than mutual funds. They can offer the investor a wonderful avenue for diversification through the use of a single product. Plus, ETFs provide investors access to markets using stock that at one time could only be traded using futures.
This is great news for equity options traders like us, because we now have the ability to use options to trade an incredibly diverse group of financial products. These include, the popular indexes you hear quoted everyday on the news, such as the S&P 500, the Dow Jones Industrial Index and the Nasdaq. Using ETFs to trade indexes such as theses give the investor instant diversification compared to buying individual stocks. In addition, ETFs give stock & option traders the ability to trade particular sectors or subsectors of both the domestic and world economies.
ETFs Versus Individual Companies
With the advent of ETFs and online trading technologies, the individual investor now has access to tools that less than 20 years ago, even professional investors only dreamed about. One big advantage is the easy access to diversification. An stock and/or option investor or trader can make a great living today without ever trading a single individual company stock. In fact, many professional investors or traders completely avoid trading individual company stock and stick to just a handful indexes. Among them are plenty that trade just a single market, the S&P 500 Index which is made up of the 500 largest companies traded on the New York and Nasdaq stock exchanges.
The gains that some individual company stocks have produced makes for great news stories and water cooler talk. But, the risks involved in owning or shorting individual companies is generally misunderstood and underestimated. The problem with a single company stock is not just the challenges that come from trying to analyze and choose a good company to invest in, it’s the ongoing analysis that must be performed. Circumstances are constantly changing and even the most well established companies are at risk. A few quick examples of some very well known companies that filed for bankruptcy and completely wiped out the stockholders are American Airlines, Sears, General Motors, the California utility Pacific Gas & Electric. That is just from memory.
Besides that risk, which proper fundamental analysis may help an investor avoid, practicing competent business analysis does not guarantee to shield the investor from the unexpected or “black swan” event. These events can come out of nowhere and can be catastrophic to the investment. An example off the top of my head is the Deepwater Horizon oil spill in the Gulf of Mexico. The oil company BP was blamed and the stock went from about $60 per share down to the mid 20’s. No amount of research would have warned you of that coming.
The point is not to scare you out of trading individual stocks, but just to make you aware that there are risks involved and it’s important that you know there is a great alternative to simply buying individual company stocks. ETFs offer plenty of volatility if desired and upside potential for bullish investors and a myriad of choices for bearish investors while avoiding risk that come with owning individual companies.
The markets available to trade via ETFs are numerous. Here is a list of some of the most popular markets.
The broad US Market Index ETFs:
SPY - S&P 500 https://www.spdrs.com/product/fund.seam?ticker=SPY
QQQ - US Nasdaq Index stocks (high correlation to SPY)
DIA - US Dow Jones Index (high correlation to SPY)
The individual sectors within the broad market include:
XLY - Consumer discretionary https://www.spdrs.com/product/fund.seam?ticker=XLY
XLP - Consumer staples https://www.spdrs.com/product/fund.seam?ticker=XLP
XLE - Energy sector https://www.spdrs.com/product/fund.seam?ticker=XLE
XLF - Financial sector https://www.spdrs.com/product/fund.seam?ticker=XLF
XLV - Healthcare sector https://www.spdrs.com/product/fund.seam?ticker=XLV
XLI - Industrials sector https://www.spdrs.com/product/fund.seam?ticker=XLI
XLB - Materials sector https://www.spdrs.com/product/fund.seam?ticker=XLB
XLK - Technology sector https://www.spdrs.com/product/fund.seam?ticker=XLK
IYR - Real Estate sector https://www.ishares.com/us/products/239520/IYR?referrer=tickerSearch
IWM - US Small Company sector https://www.ishares.com/us/products/239710/IWM?cid=ppc:ishares_us:google:IWM&&&gclid=Cj0KEQiA4eqyBRDUh7Omv9vCtsoBEiQAspfs8mL4-v013_X84yrnx02Zo5OWxJDLjPH6IFRHa3xm46saAjPz8P8HAQ&gclsrc=aw.ds
Precious metals and mining market ETFs:
GLD - holding is Gold bullion only, but we can use other products to represent this category such as:
SLV - Silver markets, holds silver and correlates with gold
GDX - Gold miner stock ETF - holds gold and metal mining companies http://www.vaneck.com/market-vectors/equity-etfs/gdx/holdings/
GDXJ - small mining companies “junior miners”
Global region ETFs:
EEM- Emerging markets
EWZ - Brazil market, correlates with energy sector
FXI - China market
EWW - Mexico market
EWY - South Korea market
EWJ - Japanese market
EWG - German market
UUP - US dollar
FXE - Euro dollar
FXY - Japanese Yen
Fixed income (bond) ETFs:
TLT - US Treasuries
LQD - Corporate Investment Grade
HYG - Corporate High Yield
Volatility index ETFs and and ETN:
VXX (exchange traded note ETN)
This is just a partial list of what’s available to trade. As you can see, ETFs offer numerous options when it comes to which market an investor wishes to create exposure to in their portfolio.
There is a popular phrase in our society that you’ve no doubt heard which states that “knowledge is power”. I argue that the phrase is completely false. Knowledge on its own is inert. The true statement is “application of knowledge is power”. That’s why your Profit Talk knowledge lessons are always followed with strategy lessons designed to apply what was learned. Now that we know EFTs are great products to trade that offer a variety of choices, let’s look at how to use the information in our trading.
ETFs offer diversification in a very broad sense such as when using an index ETF like the S&P, Dow Jones or Nasdaq. Or, the exposure can be concentrated a bit more, through the use of a sector ETF with exposure to a specific sector of the economy, such as the financial sector, the healthcare sector or the energy sector.
In addition, ETFs can be used to concentrate exposure in a very specific market, very similar to individual stock investing without the risk associated with owning one company stock. This style of investing or trading utilizes the subsector or industry specific ETFs. These allow the investor to gain exposure to the performance of an industry through ownership of a basket of the top stocks in that particular category.
One great tool to use for quickly finding ETFs to trade by sector and subsector is the heatmap tool from Finviz.com. They have a great stock screening tool, maps, portfolio analyzers and charts to view the sector performances and relative strength. The tool we need for our discussion here is found by going to Finviz.com, then go to the the Maps page by clicking the tab at the top that says “Maps”. The default shows the S&P main sectors and the largest individual companies within those sectors. The tool we want is found by using the “Map Filter” in the upper left hand sidebar. Select “Exchange Traded Funds”. (Figure 1)
On this page you’ll find the map categorized by sectors and styles. You have the main US Indexes in the upper left box, the inverse funds for the broad markets, leveraged funds and dividend specific funds.
Below those you have ETFs for the individual sectors of the US economy. The main sectors include healthcare, financials and cyclicals. Cyclicals are the discretionary products and services people don’t necessarily have to buy. They are more of a luxury item. Cyclical products and services follow the business cycle and suffer greatly in recessions. Other main sectors include, real estate, industrials, utilities, energy, technology, and non-cyclicals. The non-cyclicals are not sold off in recessions to the degree experienced by cyclicals. Non-cyclicals are items consumers still buy in recessions, such as toothpaste, soap, toilet paper and similar items. Finally, there is basic materials.
In addition to the main sectors represented by an ETF, there are sub sectors or specific industry ETFs. This allows concentrated exposure to specific areas. For example, within the healthcare sector there is biotechnology, pharmaceuticals, service providers. The financial sector is divided into national banks, regional banks, financial services, dealer brokers and insurance. The industries within the broader cyclical sector include retailers, home builders, consumer services and a media company ETF. The energy sector is broken down into a variety of different industry ETFs like oil & gas exploration and production, oil drillers, equipments and services and so on.
Each main sector contains industry specific ETFs within the broad sector. These funds allow an investor to concentrate their exposure to a particular area of the economy while avoiding the risk associated with a single company stock purchase. For example, instead of investing in a particular retailer, an investor may choose to invest in XRT and own all the top retailers. Or, if you want exposure to the banking sector, instead of going long a particular bank stock, an investor may choose to spread the risk across several large banks, or concentrate on regional banks. Instead of buying a single pharmaceutical company, the pharmaceutical specific ETF can be used as the underlying stock.
Digest this information for a moment and then think about the “Bull Round Trip” strategy that was covered in the last edition of Profit Talk. Imagine utilizing that strategy using ETFs. The degree of exposure to any particular area of the economy can be adjusted according to your personal preferences and portfolio goals.
Another example is an alternative strategy for an investor interested in exposure to the broad US market. They may choose to create cash flow from the investment by allocating the investment dollars across the 10 main sectors via ETFs and use a method such as the “Bull Round Trip” to do so. The process would involve entry into and exit out of each market via the Bull Round Trip. A strategy like that would produce monthly cash flow and provide potential for creating a substantial return on the investment compared to a passive style purchase of the broad market ETF or mutual fund while avoiding the risk associated with owning individual stocks.
The main takeaways regarding ETFs are:
First, ETFs trade just like stocks
Second, ETFs provide the ability to diversify across many stocks at once in a single product.
Third, ETFs exist for both broad and concentrated markets across many asset classes
In a moment we’ll create a scan query to help make this ETF knowledge much quicker and easier to implement in the market. As you know, when it comes to investing, properly timing the entry into the investment can add a great deal to the performance enjoyed by the effort. In my opinion, in the long run, a sound strategy has a much better chance of producing quality investment returns than trying to nail the perfect entry into a market. But, that’s not to say that developing a plan for entry should be ignored. Buying and selling at the “right’ price is a must for any successful investor. We will do a quick review of some the principal elements behind chart analysis covered previously. Then I will show you a scanning technique for finding trade candidates.
When it comes to the criteria used to determine what price to buy or sell a market there two types of analysis. Fundamental analysis and technical analysis and fundamental analysis.
Fundamental analysis uses information about the company behind the stock price. The revenue, sales figures, growth rate, earnings ratios, competitive advantage, management team, etc. to determine if the price is undervalued, overvalued or fairly valued. Technical analysis studies price and volume only. It is often referred to as chart analysis. The technical analyst’s argument is that all of the fundamental information shows up in price and volume. More than that, besides the known or public information the non-public information is displayed on the chart as well.
The fact is, there is no hiding from price. All the information will manifest in the price and volume. It is for this reason and the enormous amount of time and skill necessary to conduct fundamental analysis well, that the Profit Effect and Profit Talk philosophy employs the use of technical analysis almost exclusively. One of the biggest influences on price and a key component in the study of price is the trend. I will show you how to create a simple but powerful scan query to find prospective trade candidates using this key principle.
Trend Trade Scan
The scan query I’m going to show you is based on the theories of trend trading. The subject of trend was covered in some detail in the December 5th edition of Profit Talk called “Directional Trading Options”. Review the content their for more detail on the subject. In short, trend direction, especially the bigger picture trend direction, most often determines the trade direction.
The Profit Effect style of directional trading typically uses the study of two different time interval charts. One chart is called the “controlling time” frame and one called the “big picture” time frame. The controlling time frame is used to determine the entry zone and exit points for profit or risk defense. The big picture chart is used to determine trend direction and that determines the trade direction. The big picture chart used is 3 to 5 time larger in duration than the controlling time frame chart. The trend trade scan we’re going to create is based on these principals and style of trading. We’re going to go through the process of creating the bullish version.
The first step is to determine the controlling time frame chart. This decision is based on the time horizon for the trade and strategy being used. The most common chart used when trading options is the daily chart. We will use that as our controlling time frame. This makes the weekly time frame the “big picture” chart because it is five times larger in duration. Five trading days in a trading week.
As previously discussed, a moving average can be used to determine the trend direction of a market. This trend trading scan uses the 20 period moving average for this purpose. The particular scan we’re creating here is looking for bullish trade candidates. This means we look for markets that are uptrending. If price is trading above the 20 period moving average on the weekly chart then it is in an uptrend on that “big picture” chart. This is parameter number one for our trend trade. #1 Price is trading above the 20 period moving average on the weekly chart.
The rest of the criteria is determined on the controlling time frame, which is the daily chart in this case. For this style trend trade entry, we are looking for price trading in a zone near the 20 period moving average on the daily chart. The buy zone for this trade is between the 20 period moving average and .5 standard deviations above the average. This is parameter number two for our trend trade. #2 The entry zone is between the 20 period moving average value and .5 standard deviation above the 20 period moving average on the daily time frame chart.
The combination of these two parameters creates an entry zone in an uptrending market when price is “testing” the average. Uptrending prices tend move from the average price to some degree of extension from that price as it is trending. This scan will find trades that are “testing” the average which allows an opportunity to join the current trend.
The exact process involved creating the scan query will vary depending on the trading software you’re using, but most top platforms allow some form of scan based on the parameters outlined for this entry. I will demonstrate how to construct the scan query using the TD Ameritrade “Think or Swim” platform.
Besides the parameters that are set by the particular entry strategy, there is specific criteria I use for every scan query I create. I always create a minimum share price and volume level for the scan. The values used can be adjusted for personal preferences and will depend on the markets being filtered, but in general, I set the share price minimum to $15 or $20 per share. I don’t like to trade options on shares that are trading for less than $15 per share.
Volume refers to how many shares are traded on a daily basis. I generally use 1,000,000 shares as a minimum but since we’re specifically filtering for ETF trades, I’ll lower that figure to 500,000 shares because the volume on many of the ETFs is low. That brings us to the final parameter we’ll need to set for our scan query, which is the scan universe which want to filter. In this case we’re going to filter through “All ETFs”.
Let’s jump over to the platform so i can demonstrate how to create the bullish trend trading scan. Go to the scan page by using the Scan tab at the top of the page. Choose the “Stock Hacker” subpage if not already there. First, choose the scan universe here under the “Scan in” drop down menu. Select “All ETFs” which this platform has under “Public” lists. Next, create the stock price filter and choose “last” for last price. Then a volume filter, $500k minimum.
At this point the scan is set to search all ETFs that are trade at least 500k shares per day for $15 per share or higher. (Figure 2)
Let’s review the parameters for the bullish trend trade entry:
Price is trading above 20 period moving average on Big Picture time frame chart.
Price is trading above 20 period ema on controlling time frame chart
Price is not trading more than ½ standard deviation above the 20 period ema
On the chart price will look like this (Figure 3)
To create the filter for the Price trading above the weekly moving average click on the “Add study filter” button near the top of the scan page. Use the drop down and choose “Custom”.
Delete the default ADX crossover study that is already loaded. Change the aggregation to Week with the drop down menu. Now click the “Add condition” button. Select “price”, then “close”, then “is greater than or equal to”. Now select another study, choose the “MovingAvg Exponential” study. Set the length to 20. Now check your work. We have the close of price greater or equal to the exponential moving average set for 20 periods. Everything looks good so click save. (Figure 4) Then click OK to save that condition. The other two conditions have to be saved in a separate filter because the time frames can’t be mixed using one filter.
Open another filter by clicking “Add study filter. Use the drop down and choose “Custom”.
Delete the default ADX crossover study that is already loaded. This time leave the aggregation set to daily which is the default. Add the conditions that price close is greater than or equal to a study. This time we’ll use the “Bollinger Band Study”. The middle line on the study is the 20 period average, so make sure it’s set to that. Now select the exponential type. This is set to filter for price trading above the middle line of the Bollinger band which is equal to the 20 period exponential moving average. (Figure 5) Click save.
You can combine conditions using the same time period. So, leave the window open and click “Add condition”. Delete the default and create your own to filter for price close that is less than or equal to the study called “Bollinger Band”. Choose the Upper Band plot line and change the standard deviations to -0.5 and 0.5 by using the “num dev dn” and “num dev up” selectors. Now change the average type to “Exponential”. Click save, then make sure to click OK.
You now have a custom filter that will look for price trading above weekly time chart 20 period moving average. Plus trading above the daily chart 20 period moving and average but not more than ½ standard deviation away. The standard deviation measurement is implemented using the Bollinger Band study. (Figure 6)
Now simply click the Scan button and let the software crunch the numbers. In just a few seconds you’ll see if any markets are currently trading in the zone based on the parameters you’ve set.
We currently have 40 markets trading under the conditions we outlined with the filters.(Figure 7) Go to the scan result menu to name and save the list. Once you’ve done that you can pull up the watch list universally on the platform. The “quote window” can be customized to sort the list for a variety of information, such as IV percentile or volume, etc..
The chart page is where further analysis can be performed to make a final selection. This chart shows the 20 period moving average zone as outlined in our scan query. (Figure 8) I’ve done the same thing on the chart as I did with the scan filter. There is two bollinger band studies on top of each other, just like the scan we created. One Bollinger Band study is the default version with the average type changed to exponential. The other study has the deviation value settings at -0.5 and 0.5 with the plot display changed to a dash grey line instead of the red and magenta defaults. The second study is also set to exponential. When seen layer on each other the enter lines overlap so only one is seen. The first study’s upper and lower bands are shown in the default setting as the normal bollinger band and the second study’s upper and lower bands set to ½ standard deviation show the zone around the middle line. This line is the 20 period moving average.
A visual rendition of the 20 period moving average on the weekly chart can be created by adding a 100 period average to the daily chart. Remember, the weekly chart is made up of 5 days. This makes the 20 period average on the weekly chart and the 100 period average on the daily chart “roughly” the same value. 5 X 20 = 100. It is a good idea to do this as it puts some perspective around the current trend conditions. It’s clear that some of these markets are pretty far from the bigger picture trend average as depicted by the 100 period moving average. (Figure 9)
These conditions can reduce the likelihood of the shorter term trend line, our daily 20 period average, supporting price. When price gets ahead of itself it will often break the near term average and trade below it shortly before resuming the prevailing trend.
The bullish side of the argument says all of the broad markets are at all time highs. The Nasdaq just broke above and made another all time high. This means from a technical analysis point of view, this upward trend can continue. As always, the decision on any particular trade should be based on the current exposure in your portfolio and personal trading style.
As of this recording on last trading day of the year, December 30th 2016 the broad markets have entered the 20 ema zone I have pointed over several of the previous Profit Talk editions. Out of the three main markets which include the S&P, the Dow and the Nasdaq, two of them, the S&P (Figure 10) and the Nasdaq (Figure 11), are currently trading below the 20 period ema on the daily chart. The Dow Jones Index is currently trading in the “buy zone” as determined by the 20 ema (Figure 12) . In addition, the more speculative small cap index, ticker symbol IWM is currently trading in the 20 ema buy zone (Figure 13). This means the signals are a bit mixed which is not surprising as I wouldn’t expect much of a stand to be taken by the bears or the bulls on the last trading day of the year.
A new year typically brings some volatility as portfolios are rebalanced. A new year with a new administration in the white house can bring even more volatility. Personally, this is music to my ears. I’m looking forward to some activity in the markets and I don’t think 2017 is going to disappoint.
The economic reports coming out this first week of the year include a lot of high impact names including:
Tuesday 1/3/17 - ISM Manufacturing PMI
Wednesday 1/4/17 - Crude Oil Inventories and FOMC minutes
Thursday 1/5/17 - ADP Non-Farm Employment Change, Unemployment Claims, ISM Non-Manufacturing PMI
Friday 1/6/17 - Average Hourly Earnings, Non-Farm Employment Change and Unemployment Rate
All these reports have the potential to move the market.
A Look Ahead
In the hopes of a high volatility and therefore high IV Percentile environment in the coming weeks we’ll cover the details of analyzing and constructing an option strategy designed to capitalize on high IV Percentile situations. The strategy is called a “Short Straddle”. The Short Straddle is another favorite cash flow strategy that can be used on any markets that trade options including the ETFs highlighted today.
I hope this has been helpful for you. If you have any questions or comments, please leave them below or reach out on social media. You can also email me directly with any questions or comments at email@example.com.
Thank you so much for being a Profit Talk subscriber. I look forward to joining you for next week’s edition of Profit Talk. Until next time keep trading and investing the Profit Effect way proven, consistent and stress free, just the way trading is supposed to be.