Deciding on ETFs

Fitting Your ETF Selections to Your Plan

There are a lot of different things to invest in and to trade when it comes to selecting ETFs, and what you ultimately decide upon should first and foremost fit the plan that you are using to invest or trade.

Choosing ETFs first and then coming up with a plan to trade them based upon one’s selections is an amateur mistake, but one that many professionals make as well. The main issue with this mistake is that it does not provide a good strategy for seeking out the most profitable trades or investments based upon what you can achieve.

Deciding on ETFsIf you select a particular ETF for instance, based upon wanting to invest in it or trade it, there may be something better that you could have selected that would better suit your style or perhaps simply be something that is better to go with overall, one that has superior objective features that make it easier and more profitable to go with.

Even when this is the case though, when an ETF may be superior in the way it performs objectively, this may not mean that it may be superior for you. For example, if something is easy to time using daily bars, and you are an intraday trader, that will not matter, and it may turn out that the ETF trades too spastically intraday versus other choices that could be made that would provide more reliable and profitable signals.

What we often tend to do as investors and traders is to apply criteria that isn’t particularly related to what we are seeking to accomplish, such as a view that gold may be bullish right now, or a certain sector of stocks might be something that we may want to invest in, without really looking very hard at how the way it trades may fit our trading or investing style.

What we need to be doing instead is examining the performance of the ETF as far as how this fits into our strategy and style that we want to be using to trade or invest in it. It’s fine to factor in these objective views that we may have about an ETF, but ultimately it does come down to a matter of fit with our own style and preferences, when it comes to deciding between ETFs to take positions in.

To Do This Effectively, We First Need a Good Plan

There always is a plan involved when one trades or invests in something, even though the plan may not be a very good one or even a terrible one. Trading and investing isn’t about just taking a position in something, in our case an ETF, it’s about taking one with a plan and having a plan to exit as well.

These are the two components of any plan, what will cause us to enter a position and what will cause us to exit it. The plan may even be to just hold it and not allow any changes in its direction to influence us to exit, and even this is a plan, even though it’s a plan to never do anything, at least in terms of managing our position.

Perhaps we plan on exiting when we need the money, but this isn’t managing the position of course. From there, we may come up with a number of different criteria to manage our trades, whether this be based upon fundamental criteria, technical ones, or both.

There are quite a few factors that we may be taking into account in arriving at these decisions, but whatever they are, if we select ETFs based upon how well their performance conforms to these strategies of ours, we’re going to be putting ourselves in a better position to have success with the strategies.

For example, if we are basing our decisions upon a certain signal, a certain technical indicator for instance, some ETFs will perform more reliably with our signal than others. If we choose them at random, this will not tend to produce as much success as if we look to discover ones that fit our signals better based upon past performance.

This is by far the most important criterion in selecting ETFs to trade or invest in, and while this matters more to traders than investors, it always matters regardless of your investment or trading timeframe.

We still want to look to optimize our signals and strategies based upon fitting the performance of the ETFs we select, but by focusing on those that fit our style more initially, we will be more likely to be on the right track and any adjustments that we will benefit from will be easier to make and also tend to be more refined.

Components of Good ETFs

In addition, we will also look to select ETFs based upon other criteria, where we will view them in terms of their desirability in general based upon these factors. For instance, the size of the spread and our overall trading costs will matter at least a bit, and the smaller our profit objectives are generally with a position, and generally the shorter the timeframe of the position, the more this will matter.

It is not enough to just look at what the liquidity is or what the spread is at any given moment, when we’re looking to enter a position for instance, we also need to be aware of what these conditions are generally, and in particular, what we may expect when it’s time to close the position.

More liquidity is better generally, and tighter spreads are preferable to wider ones, since this makes it easier to enter and exit positions and also reduces trading costs. This is just one of several factors we need to look at when deciding which ETFs to trade though, and we don’t want to give too much weight to this.

Liquidity is generally more of an exclusionary criterion than anything, meaning that a lack of this may cause us to not want to trade the ETF, and if liquidity is sufficient for our purposes, we want to then look at other factors which may influence our decision to enter.

Predictability is even more important, because no matter how liquid an ETF may be, if it does not behave predictability enough, we’re going to be in trouble.

The goal of trading or investing, not just one of the goals but the goal itself, is being able to predict changes in price accurately enough. While there is never certainty here, what we are after is making predictions which have a high enough probability of success to be profitable. The higher the probability, the more success we will have.

It is not enough that something moves in a certain direction, we also require that it does so in a tradable manner, one that allows us to stay in the trade or investment to capture enough of the move. If the ETF moves too choppy, it may go our way ultimately but expose us to too much risk along the way and we may be faced with deciding between taking on too much risk and not allowing the trade to be profitable, and neither should be acceptable.

Volatility is another criterion that we need to pay attention to, which is also tied in to predictability. Volatility itself is desirable with trades and investments, because we want the ETF to move, but we also need it to move in a way that is predictable enough.

Ease of Trading is Also Very Important

Looking to balance volatility and predictability may seem to be pretty daunting to many, but this need not be too complicated of a goal to seek. What we’re looking to do here essentially is to take our style of trading and investing and both looking to find ETFs that both provide good profit potential and are also easy to trade, and ease of trading is a very important criterion indeed.

Ideally, we’d be taking positions in ETFs that move steadily in our direction, form a clear top at some point, and then go the other way in a similar fashion. Unfortunately, securities do not behave that way, and there are always a number of smaller trends along the way. These ups and downs of a more minor variety is what makes trading and investing more challenging, but if things were that easy than this would remove the advantage of skill that good trading and investing profits from.

What we want to seek though is ETFs that more closely resemble the ideal, ones that are more predictable than others, ones that we can more easily distinguish the trends that we’re looking for more easily and not get fooled so much by the more minor moves against us.

Generally, ETFs with a lot of liquidity will tend to be more predictable, but we can’t rely on liquidity alone, we have to look at the actual performance. For example, SPY, which tracks the performance of the S&P 500, has the most liquidity of any ETF, but it also behaves in a fairly predictable way compared to many ETFs. Its liquidity has something to do with this but there are other factors involved here as well, and the only way to really decide this is to look at charts in the timeframe desired and see how an ETF measures up.

It’s far easier to decide whether a certain strategy will work with a chart when you’re looking at past data, than it is dong so in the heat of battle, but if a chart does not fit our strategy that well you can bet that we’re going to have trouble with the ETF in the heat of battle.

If we do struggle with our decisions and find that something is more difficult to trade than we imagined, this is a reason to give us pause as well, although this issue does pertain to shorter term trading than investing, where the decisions are fewer and the room that the trade is provided to move against us is wider.

Selecting ETFs that are easier to trade is probably the most important criterion though as far as choosing between them, although this does require at least a bit of homework in looking at charts.

Even fundamental traders need to use charts, because they will be looking at them after the trade is taken, so it’s important to look back upon them to see how this might influence their behavior even when one is not looking to rely on charts primarily.

It does take some effort to be in a position to make the right decisions as far as which ETFs to take positions in, but this is time well spent and if you are going to invest your money you also need to at least invest a little effort as well.

Ken Stephens

Chief Editor, MarketReview.com

Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.

Contact Ken: ken@marketreview.com

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