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Tharp's Thoughts Weekly Newsletter

September 24, 2008 — Issue #391  
  
Hot Off the Press

The Definitive Guide to Position Sizing Is Here!!!

Article

How ETF Strategies Work in Extraordinary Conditions by Ken Long

Workshops

October Workshops 

Trading Tip

All-Time High Volatility by D.R. Barton, Jr.

Melita's Corner

It Is Simply Enough by Melita Hunt

 

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Feature

The following article about ETFs was written by our ETF expert and workshop instructor, Ken Long. We asked Ken to educate our readers on the basics and benefits of trading the ETF sector.  Ken has expanded his workshop teachings into an ongoing learning environment via a mastermind internet forum. We hope that you enjoy this introduction into the world of ETFs.

 

How ETF Strategies Work in Extraordinary Conditions 
(like those that transpired last week)

by
Ken Long

Exchanges Traded Funds (ETFs) are one of the most important and timely investment vehicles available to the trader or investor who wants to take control over his own financial future. Here are just a handful of the important qualities of ETFs you should be aware of.

  1. ETFs have useful variety. No matter what kind of ETF you need for your trading or investing interests, you are sure to be able to find an ETF that’s right for you.  You can find ETFs that track any of the following:
    1. Broad Indices: These are indexes like the Dow 30 industrial average, the S&P 500 index, and the NASDAQ 100. Their symbols are DIA, SPY, and QQQQ. There are other major indexes like Japan Nikkei (EWJ), the European large-cap 350 (IEV) and the Morgan Stanley European and Asian mature company index (EFA). EFA is a particular favorite of mine because it represents the mature industrial world minus the US. 
    2. Major Market Sectors: These include ETFs for the nine sectors of the S&P 500 known as the sector SPDRs or "Sector Spiders". These ETFs symbols begin with an "x" and include finance, industrial, consumer staples, utilities, and technology among others. These are very high volume, very liquid and can be traded with options as well as in direct trading.
    3. Regions of the World: These correspond to different regions of the world markets such as Asia less Japan (EPP), European and Asian mix (EFA), Latin America (ILF), and emerging markets (EEM).
    4. Individual Countries: There are over 30 separate countries with their own ETF. These typically reflect the stock markets of each country comprising the largest capitalized companies, for example, Canada( EWC), Mexico (EWW) and one of my very favorites Brazil (EWZ). The Brazil ETF is very liquid and represents a country that is quickly turning into the economic powerhouse of Latin America in the Western Hemisphere. 
    5. Business Sectors: These include specific market segments such as semiconductors (SMH), utilities (XLU, UTH), regional banks (KRE), US residential real estate (RWR), biotechnology (BBH), and medical devices (IHI). 
    6. Individual Commodities & Baskets of Commodities: This has been a very hot sector over the last year and the run may be done. Commodities tend to be cyclical and very volatile at the end of long trends. You can either buy baskets like the Deutsche Bank commodities blend (DBC) or an ETF that reflects individual commodities such as gold (GLD, IAU) or grains (DBA). 
    7. Currencies & Currency Pair Trades: The seven major currencies of the Forex market can now be purchased as ETFs including the US dollar (USD). You could even get sophisticated pair trade ETFs which play the difference between currency pairs. This is sophisticated trading that is not for novices. 
    8. Morningstar Style Boxes: there are ETFs that correspond to different styles according to them and MorningStar style box framework, such as large-cap value or small-cap growth. 
    9. Proprietary Fundamental Screens: There are even ETFs that reflect specific investment strategies and hypotheses. These all tend to be very sophisticated strategies and in order not to lead you astray I will refrain from reporting their symbols. It is enough to know that any philosophy of investment or trading can be framed with an appropriate set of ETFs. 
    10. Varieties of Bonds and Income-Generating Dividend Payers: A couple of easy ones are long-term treasuries (TLT) and aggregate income that mixes treasuries and corporate bonds (AGG).
    11. The Entire World Market: A simple example is the Vanguard Total Market Index viper (VTI).
  1. ETFs have more transparency. Mutual fund components are effectively screened from public view, so you cannot analyze your current exposure. That can be very important as we saw this week. You’d like to be able to know what your exposure to companies like AIG, Lehman Brothers and Bear Stearns might be at some moment. You can get this kind of information in a timely manner with ETFs (WisdomTree ETFs are especially noteworthy in this regard).
  1. ETFs are less volatile than stocks. There are times when the day to day fluctuations of price can upset even the sturdiest of stomachs.  Because they are blends of multiple stocks or commodities, ETFs have a much smoother price curve than individual stocks.
  1. ETFs have enough volatility to be tradeable.  Even though the price action of ETFs are generally much smoother than stocks that make up their components, there is plenty of price change for traders to be able to frame trades that offer favorable reward:risk characteristics. In a way, you can say that ETFs trade jagged volatility for more smoothly oscillating waves. ETF price waves are more like the long, powerful ocean swells that move for miles in deep water.
  1. ETFs can be compared for purposes of market research. Because there are ETFs that cover the entire world market, as well as business sectors, countries and currencies, it is possible to rapidly assess the condition of the world market by doing a regular comparison of price performance between a set of representative ETFs.  Because price rolls up all the variables and market opinions of market participants who vote with their money, ETF price action serves as a barometer for market health and opportunity.
  1. ETFs can be analyzed using your favorite technical analysis.  Because ETFs buy and sell on exchanges just like stocks, they are subject to all of the technical and fundamental analysis that you use on individual stocks.  So the good news is that you don’t have to jettison the principles and techniques that have served you well already. ETFs allow you to leverage your time investment in mastering your niche in fundamental and technical analysis.
  1. ETFs can be used to construct any kind of portfolio you seek. Sometimes you need a core portfolio to take care of your long term financial goals. Sometimes you need a short term hedge to protect gains in long term holdings that you don’t want to prune or to seize an opportunity caused by a short term imbalance in price and market conditions. Sometime you just need to get money working in a sector now while you prepare to conduct a more detailed analysis of individual companies. No matter what kind of portfolio solution you are looking for, chances are there is a set of ETFs ready-made to answer the call.

ETFs are here to stay. The prudent investor will approach them with care and interest to see just how you take advantage of the many favorable qualities they offer to both the  trader and the long-term investor.

I recently received a very timely question about ETFs, “How do the ETF strategies you teach handle extraordinary conditions like those that transpired last week?"

It was a great question and I want to share my two answers with all of you.

First, in our intermediate and long term systems, market conditions have deteriorated so much in the past couple of months that we have been near 100% cash for the last several weeks, which is not a bad place to be as the market works through some historically large volatility.

Second, in our short term strategies we have been able to take advantage of some short term anomalies that worked out very favorably.

Below are two live shots from inside our live trading room from last week.

And this is not about me being a genius, far from it. This is an example of the mastermind effect of ETF traders working together to share insights that made the difference. Our common frame of reference allowed us to pool our observations and insights.

We made the observation that UYG (the 2x leveraged  Financial sectors ETF) was at extreme "Maxpain" conditions (a technique we describe in the seminar).

Chart 1 shows the setup, and we took positions at 15 with a $.50 initial stop

 

Chart 2 shows the follow through, when we sold into strength the next day

 

On Thursday (9/18), intraday, there was an easy and orderly exit possible at 19 for anyone who didn’t want to hold overnight for an 8R intraday trade.

On Friday morning, we sold into strength at 23 for a 16R overnight trade, banking a nice trade and carrying no overnight risk.

On Friday afternoon some of us made the case that financials may continue to benefit from the government's willingness to secure the downside of the trade, and we framed a trade for next week that so far hasn’t paid off, but we are within our normal risk managed parameters. But that's the nature of trading after all. You look for an edge and establish a trade that seeks to exploit it in a risk managed way.

Now, these opportunities don't come along everyday, but if you are paying attention, and are leveraging the power of a trader mastermind of trusted friends with multiple points of view, there are times when you can frame really favorable short term trade with ETFs.

Our chatroom discussion continues as of this writing on looking for and interpreting opportunities in the financial and commodity sectors that seem to be setting up for a rebound after a 30-40% selloff from previous recent highs.

There will be an opportunity for ETF seminar attendees to join our mastermind chatroom at a reduced rate. Chatroom members are also eligible for annual follow up workshops, and monthly webinars to keep the momentum going.

About the Author: Ken Long, a retired Lieutenant Colonel in the U.S. Army with a Master's Degree in System Development, is currently a professor of tactics and logistics at the Army's Command and General Staff College. He has developed the Tortoise Method of mutual fund switching, a trading system that takes about five minutes each week with a goal of outperforming the S&P 500 Index.  Ken is the instructor of our upcoming  ETF Techniques Workshop, and a co-presenter with Van at our Blueprint for Trading Success Workshop. Ken is founder of Tortoise Capital Management, www.tortoisecapital.com.  He is a trader and writes a daily and weekly market assessment for mutual funds and exchange traded funds. He is a proud husband, dad, and ju jitsu practitioner. 

IITM Third Party Clause

 

Workshops

October Workshops

October 11-13, 2008

Cary, NC

Blueprint for Trading Success

"This is the best conference I have ever attended. This is the hardest conference I have ever attended. I had to ask myself some of the most difficult questions I've asked in a long time...Van and Mel are not just great trading coaches, they are great people. You are a breath of fresh air in an industry full of hucksters." —S.W., Rancho Mirage, CA

October 15-17, 2008

Cary, NC

ETF 101 Workshop

"Excellent course for understanding ETFs and how to incorporate them, both short-term and long-term into your trading plan. Ken is an excellent instructor with a terrific commitment to making sure everyone understands the material. He is one of the best, if not THE best trading and system design instructor I know." R. Freeman, CA

 

Trading Tip

All-Time High Volatility:  
What’s a Trader or Investor to Do?

by
D. R. Barton, Jr. 

My 14 year old son (and new golf aficionado), Josh, ripped a drive right down the middle of the fairway on the first hole of our local golf course.  While this didn’t assure a good outcome on the hole, it was fairly routine for him to use this good starting position, put some good shots together and par the hole.

Contrast that outcome to the second hole – where he pushed his drive to the far right, behind some trees.  From there he had to chip back to the fairway and struggled to just make a double bogie (two strokes over par).

Consistency is a huge advantage in golf.  If a player has a high degree of variability in his or her swing, then shots go all over the place, and it’s tough to make good scores.

Variability’s counterpart in trading and investing in volatility.  When the markets zip down 4 percent one day and up 3 percent the next, it’s really tough to have a strategy (and psychology) that allows you to stick with trades.

Add that to the big bear run we’re part of and traders in all time frames are facing big challenges.

Volatility at All-Time High

It is a very rare thing to use the term “all-time high”.  But on an absolute point basis the volatility in the market as measured by the S&P 500 index’s Average True Range (ATR), hit just such a milestone yesterday (Tuesday 9/23).  Average True Range provides us with the daily range of the item being measured, taking into account gaps.  The default setting is for a 14 period average.

In April of 2000, the previous high was set at 43.54 S&P 500 points.  Yesterday, this indicator hit 43.61.  To give some perspective on how volatile the markets are, the 14- day ATR has been as low as 7.73 in the past three years.

What’s a Trader or Investor to Do?

Next week we’ll talk about the market implications for day traders and swing traders.  The bottom lines is that day traders are loving the volatility and swing traders are most having to reduce time frames and position size while widening stops.

Since long term traders and investors are less affected by day-to-day volatility (except psychologically), their main concern is about overall market direction.  And it has certainly been a rough ride for those managing long term portfolios.

Since the October 11, 2008 high, the S&P 500 cash index has dropped 28.1 percent.

With the severe credit contraction that we’re suffering through in the financial markets, there are many folks who have reached their pain threshold and believe that this is the time to get out of their long positions in stocks.

There are no sure things in dealing with the markets, but for those still holding broad-based stock positions, the strongest case right now is to weather the current storm with and establish an exit point if some combination of government intervention and an extremely oversold market can produce a near-term rally.

In short, whether or not you like the government plans to inject capital and backstop bad loans, my good friend and market maven Christopher Castroviejo says the government action, “Effectively takes the most urgent bearish case off the table.”

Add to this the effect that the four year election cycle has on the markets leading into the November 4th national elections, a market that is very stretched to the downside, and the most likely scenario seems to be relief rally.

HOWEVER, even if analysis, hope or prayer leads one to look for an upward move, we still have to have an exit strategy if the market continues to deteriorate.  Here’s a chart that shows Fibonacci retracement levels from the October 2002 lows to the October 2007 highs that might be useful to give us exit strategy clues.

The chart gives us a good long-term picture of the market. The purple moving average (MA) is the 200 day MA, and you can see that we’ve broken clearly below that.

The main problem with getting out of long positions now is that the outside interventions and normal technical oversold indications provide some strong reasons to believe that the worst of the near-term decline is behind us.

Two exit strategies could be used by long term traders still holding significant positions – a close below last week’s low would be an aggressive exit point, but that type of price action would indicate that the government intervention is being seen as ineffective by the market.  A more conservative exit place would be the one listed on the chart: a weekly close below the 0.618 retracement level.  In Fibonacci analysis, this would signal that the long uptrend from 2002 – 2007 has been broken.

Next week we’ll look at some market implications for swing and day traders.  Until then --

Great Trading,

D. R.

About D.R. Barton:  A passion for the systematic approach to the markets and lifelong love of teaching and learning have propelled D.R. Barton, Jr. to the top of the investment and trading arena.  He is a regularly featured guest on both Report on Business TV, and WTOP News Radio in Washington, D.C., and has been a guest on Bloomberg Radio. His articles have appeared on SmartMoney.com and Financial Advisor magazine. You may contact D.R. at  “drbarton” at “iitm.com”. 

Melita's Inspirational Corner

It Is Simply Enough

I was lucky this week that I had two things happen that brought me a lot of joy. The first was a dinner at Van Tharp’s house that we hold occasionally between workshops to meet, greet and spend some personal time with our clients. Being a social butterfly, I just love attending these events and especially meeting the people that are engaged in and enjoying Van’s work. We have a really easygoing time and talk about day to day things, learning about one another and enjoying each other’s company, as opposed to talking about the stock market and trading. There is plenty of talk about those subjects during the workshops themselves!

I didn’t overdo it because one of our clients was smart enough to remind me to conserve my energy so that I could continue to get well, rather than wearing myself down with extended chatter until my energy was spent and I was worn out, I heeded the good warning and headed home after a couple of hours, but definitely in good spirits.

On the same day, my cousin Brad arrived from Australia to keep me company for a week. He has been offering to come and visit with me for a quite a while and has always been willing to jump on a plane immediately if things weren’t going well or if I needed him for any reason. Thankfully, things are going well at the moment, but he still made the long journey over to see me and I must say that having family here with me is wonderful.

For the first 24 hours, I was trying to work out where I should take him so that he wouldn’t feel bored or disappointed. I offered him a trip to Washington DC, or a 3 ½ hour drive down to Kitty Hawk to visit the area where the Wright Brothers flew the first plane. However, he made it very clear that he wasn’t here to travel this week, or see anything in particular, unless I was feeling well enough to make a trip and wanted to traipse around sightseeing. He was simply here to see me and didn’t need anything fancy or frivolous to pass the time. Catching up and seeing me during this time was simply enough.

And his comments made me realize that spending time together really is simply enough. Just as meeting and greeting clients, even if it is only for a brief time, is simply enough.

I am very blessed to have such a wonderful family. I really couldn’t (and wouldn’t) ask for any better. From across the oceans (Australia, England, New Zealand and the US) we probably stay in touch more readily than people who actually live close to one another. Now you may think that it is my illness that has brought us closer together, but I beg to differ. I cannot think of a week that has gone by in my 40 years that I have not spoken to my mother, wherever I happened to be in the world. And with sisters, nieces, nephews and close to 40+ first cousins (and plenty of aunts, uncles and others to add to the brood), there is always something going on to hear or talk about.

Whether your family is large or small, I hope that you take the time to share yourself with them. You may not realize that the simple and brief contact can actually bring joy to others, and you might even find something enjoyable for yourself while catching up.

So I just wanted to share once again that two things brought a lot of joy to me this week. It was taking time to meet both new people and regular clients who follow and benefit from Van’s work and spending time hanging out with my cousin.

So whether you find yourself in the midst of strangers, friends, or among family members that have known you for your whole life. Enjoy every moment that you have together. You really don’t need to expend a lot of energy to entertain them or make big plans to show that you care. It is simply enough to just be yourself.

Melita Hunt is the CEO of the Van Tharp Institute and a regular contributor to the weekly newsletter. If you would like to keep up with Melita’s progress regarding her lung cancer (she is a never-smoker), please feel free to read her blog at www.myleftlung.com. You can contact Melita at mel@iitm.com

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