ETF Country Plus Strategy Insights: How to Trade the ETF Models (Part 2)

Mish Schneider | November 24, 2014

Our current three positions are TMF, SSO, and IFN. There were no position changes in the country model this week. The stops and targets model is in 2/3rds a position of IFN, full position in SSO, and stopped out of TMF.

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This Week’s Strategy Lesson: How to Trade the ETF Models (Part 2)

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Last week we opened this series covering the overall objectives and basic rules that shape the contours of the ETF strategies. We also talked about the role that the Trend Strength Indicator plays in determining our holdings as well as how you would initially deal with position sizing. This week, we wanted to continue by covering stops and targets.

Pure Rotation

When we were first designing and building the ETF models, we initially did not use any stops or targets. Instead we used a “pure” rotational strategy—meaning we were essentially always long the top three ranked ETFs (as long as there were at least three with a positive TSI score). While there were no explicit stops in this style, the rotation methodology combined with the requirement that the TSI be positive and the inclusion of short exposure ETFs actually worked very well and created a form of a “synthetic” stop.

In this scenario, if one of our positions began to go down, the TSI would also begin to track lower. Depending on the relative ranking and score, there were three possible actions the model could make: 1) We would either rotate into another long leader if it had better relative performance. 2) We would go to cash if the TSI went negative and there were no other leaders. 3) We would get into a short exposure ETF (like SDS, VXX, TLT, etc…) if that became the new leader.

While this rotational model has excellent performance, there are a few things that come with it. For one, this style typically has a higher overall volatility. Since we are almost always fully invested, we are subject to larger potential equity swings as the markets move up and down.

Secondly, we rarely take profits at the highs. Since our only real way to “take profits” is to sell our full position and rotate into another position, this doesn’t occur very often at the highs in a rotational model.

Typically, if we are in a successful leader, it’s putting in new highs and bumping up the TSI score along the way. In theory if the trend is over and the ETF hangs out near its highs, over a period of time the TSI score will gradually go down and we might rotate out at the highs. But what is more likely is after a big run an ETF might pullback a little from the highs and depending on the relative strength of the other ETFs in the model, we would typically give back some of the gains before the position change would be triggered.

Stops and Targets

Stops and Targets are specifically designed to counter these effects. When implemented correctly, stops give trades enough room to breathe while capping loses and targets can often take profits at or near the highs and taking partial profits reduces your position and possible exposure to swings in the markets.

Of course, using stops and targets are not without their own set of drawbacks. Just as a stop can prevent further losses, it can also lock your losses in at what might turn out to be the lows. And if your targets are too tight, you could end up dramatically reducing your profits on a larger longer-term move.

So with everything, it’s a matter of finding the right balance between these competing objectives. And sometimes you get it just right, most of the times it works as intended, and a few times it doesn’t.

In just the sector model, we had examples of both recently. With the selloff in October, treasures started to really gain momentum. We got into a TMF trade and eight days later it surged briefly to our first target. We took some profits near the highs and were stopped out on the rest at a profitable trailing stop that is still above the recent price action.

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However, we also had an unfortunate situation in a CURE trade where it went down just low enough to hit our stop, locking us out of a quick recovery and an eventual profit target.

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Our back-testing of the stops and targets revealed similar results. There were a few years that it improved the results and a few where it reduced the return, and while it did tend have a small reduction of overall performance, it also had a proportionately larger reduction in volatility.

The current stop and the next target for each position can be found on the open positions page (stops and targets specific versions of the Sector and Country models). For the most part we use liberal stops and targets. The stops rarely come in to play and while the targets are hit more often, the majority of trades will still be opened and closed based on a rotational methodology.

When a position either gets stopped out or reaches its final target, it remains in cash until the model generates a fresh signal. This means, for instance, that if you are stopped out on a profitable trailing stop in TMF, you have to wait till TMF falls sufficiently out of the top three and model issues a new rotation alert before you get a new holding in that portfolio slot.

We do have some rules for reentering a position which has been stopped out of if it remains a leader, but we will not get into those rules here and when this criteria is met, the model will issue a buy alert.

Next week we will cover how the model handles rebalancing.

The Current Condition of the Model

For the country model, we are in TMF, SSO, and IFN. Treasuries showed some rebound while the broader market continued higher, putting in a new all-time high on Friday on news of lower rates in China and possible continued stimulus in the Eurozone.  IFN continues to do well and is about 50 cents away from its next target.

Stay tuned to daily updates for any position changes.

Here is a summary of the weekly performance of all the ETFs that the strategy monitors:

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Best wishes for your trading,

James Kimball
Trader & Analyst
MarketGauge