The Wagner Weekly
August 26, 2002

ETFs - Getting efficient executions (Part I - Follow The Index)

 For the next several weeks, I will be discussing how to get efficient executions on ETF orders. Since many of you are new to trading them, I will be sharing what I have learned from trading them during the past six months. This week we will discuss the importance of following each ETF's respective index for making trade decisions. I will also show you an ideal way to set up some of your ETF charts. My goal is to make you an expert in getting the best ETF executions as we all work together to become ETF trading experts!

The most important thing I have learned for getting good ETF executions is to always follow each ETF's respective index and use it as the basis for making entry and exit trade decisions. For example, if I am trading BBH, the Biotech Index HOLDR, I will always follow and chart $BTK, which is the symbol for the Biotechnology Index. If I am trading SMH, the Semiconductor Index HOLDR, I follow $SOX, the symbol for the Semiconductor Index. If I trade QQQ, I follow $NDX. Get the idea?

I get a much better feel for the true direction of the sector by watching its respective index. Because each sector index is comprised of a more diverse group of underlying stocks than the respective ETF, it is more accurate to watch the index instead because it will trend even smoother than the ETF. The bigger the spread on the ETF, the more important this technique becomes because it gives me a better idea as to where to place my limit order to try to get filled. If I am trying to buy or sell short an ETF HOLDR that has a big spread, knowing the relative strength or weakness of its respective index tells me how good of a chance I have of getting filled if I try to buy or sell short at a better limit price than the prevailing market. Although some of the ETF HOLDRs and Index Funds can be a bit too illiquid for day trading or scalping, they are excellent for the types of multiple-day swing trades that we focus on because getting perfect fills is not as crucial. Let's look at a real live example that occurred last Thursday.

On August 22, one of the plays in The Wagner Daily was to buy OIH (Oil Service HOLDR) if it triggered past a price of 54.80, which it did within the first 30 minutes of trading. As soon as it triggered, I noticed that the specialist widened the spread on OIH, which made it difficult to know at what price to place my limit order to buy. Wanting to be sure if the rally was for real, I quickly consulted a chart of $OSX, the symbol for the Oil Service Index. I immediately realized there was a lot of relative strength in the index because $OSX was consolidating at the high of the day as the broad market was selling off. Therefore, I felt much more comfortable simply paying the offer for OIH because I was confident it was going to go much higher, which it did. By the end of the day, we netted more than 2 points on the trade. However, if I didn't consult the $OSX chart first, I may have never entered OIH because I would not have been as comfortable with paying up due to the large spread.

Let's look at what might have happened if the opposite scenario occurred last Thursday. Suppose that OIH triggered at 54.80 and once again had a large spread. We once again consult the chart of $OSX, but this time notice that the Oil Service index has simply been in a sideways trading range, chopping around, and is not showing much strength. This would cause me to believe that the specialist is just trying to suck in buy orders so he can quickly drop his offer and cover his shares for a profit a few minutes later. If I saw that scenario, I would either wait for more confirmation before buying OIH or place a buy limit order closer to the bid price rather than just paying the offer. In the event I did not get filled, just as well because the sector would not really have been that strong yet anyway. I will gladly pay a higher price later for the increased chance of the trade going in my favor.

While the biggest benefit to following the indexes is in executing less liquid ETFs, I have also found a benefit to watching the respective indexes of even the most liquid ETFs, which are QQQ and SPY. Even though both of these ETFs typically trade with a one to two cent spread, I have found that watching the Nasdaq 100 (NDX) and S&P 500 (SPX) is very beneficial during times of choppiness in the markets because it prevents me from getting shaken out of an otherwise good trade. Here's why. . .

If you watch QQQ and SPY trade on a level 2 screen (which is not necessary if you are exclusively swing trading them), you will notice that both of these ETFs possess a high concentration of ECNs such as Island, REDI, and Instinet on both sides of the market. Although I will get into ECNs in more detail in next week's issue, the main thing I want to make you aware of is that the intraday scalpers and momentum traders will often cause crossed markets with the slightest movement in the market. For those of you who do not know what a crossed market is, in this case it means that the ECN bid will be higher than the specialist's best offer or the ECN offer will be lower than the specialist's best bid. When you see this type of price action, it can often cause you to panic and stop yourself out, even though the Nasdaq 100 futures or the S&P futures may have barely moved. However, if you are watching the actual Nasdaq and S&P indexes instead of the underlying ETFs, you will not be subject to the jumpiness of the ECN traders who often only make a difference of a few pennies anyway. Once you see the actual market index make a solid move, THEN you can make a better decision to take your profits or your stop without doing so prematurely.

The easiest way I have found to follow both the sector index and its respective ETF is to set up a series of charts on your trading software that look something like this:



This is a 5-minute intraday chart that overlays $OSX (the green line) with OIH (the pink line), which allows you to see how one is trading relative to the other. I prefer a basic line chart because it is easier to see convergence or divergence with a line chart. I do, however, use a candlestick chart when viewing only one stock or ETF at at time. I recommend you set up overlay charts with each index and HOLDR so that you can quickly view price divergences (which also illustrate ETF arbitrage opportunities. . .but that's a whole different story). Here is a partial list of ETFs and their associated index symbols to get you started. You may need to check with your data provider regarding the format of the index symbol (some use a dollar sign, others don't):

ETF Symbol Associated Index Symbol
QQQ $NDX
SPY $SPX
DIA $INDU
SMH $SOX
BBH $BTK
OIH $OSX
PPH $DRG
SWH $GSO
RTH $RLX


Following the index is only one component to getting good order executions, and there are many other areas we will be discussing in subsequent weeks such as where to route your order and whether to use market or limit orders. With experience, you will become a master at getting efficient order executions.

Deron's Weekly Report Card

 Last week marked the second full week of exclusively trading ETFs in The Wagner Daily. So far, I am noticing an interesting trend that the trades that trigger have a higher winning percentage than the stock trades we used to do. In addition, I have noticed during the past six months I have been trading ETFs that the overall drawdowns in my account are much smaller than they used to be. I attribute this largely to the fact that ETFs trend more smoothly than individual stocks, decreasing the percentage of time we get whipsawed out of a position. The diversification factor also greatly minimizes risk for taking ETFs overnight. While I do admit that exclusively trading ETFs can sometimes be a bit more boring than trading high-flying stocks, I am not in this game for thrills. My only goal is to make consistent profits with minimal risk, and ETFs are a great way for me to do so.

Here is a cumulative performance summary of the trades that were mentioned in The Wagner Daily for the past week of August 19 - August 23, 2002. We had another solid, profitable week:

Number of trades targeted: 11

Number of trades triggered: 8

Number of closed winning trades and total gain: 6 trades, + 7.85 points

Number of closed losing trades and total loss: 2 trades, (1.57) points

Number of open positions and current gain/loss (based on closing prices): 2 trades, + 1.87 points

Odds and Ends

 We have a number of exciting new features we have added in our mission to become The Leader In ETF Trading:



As always, thanks for spreading the word about us!

Yours in success,

Deron M. Wagner

DISCLAIMER: There is a risk for substantial losses trading securities and commodities. This material is for information purposes only and should not be construed as an offer or solicitation of an offer to buy or sell any securities. Morpheus Trading, LLC (hereinafter "The Company") is not a licensed broker, broker-dealer, market maker, investment banker, investment advisor, analyst or underwriter. This discussion contains forward-looking statements that involve risks and uncertainties. A stock's actual results could differ materially from descriptions given. The companies discussed in this report have not approved any statements made by The Company. Please consult a broker or financial planner before purchasing or selling any securities discussed in The Wagner Weekly ( hereinafter "The Newsletter"). The Company has not been compensated by any of the companies listed herein, or by their affiliates, agents, officers or employees for the preparation and distribution of any materials in The Newsletter. The Company and/or its affiliates, officers, directors and employees may buy, sell or have a position in the securities discussed in The Newsletter and may profit in the event the shares of the companies discussed in The Newsletter rise or fall in value. Past performance never guarantees future results.
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