You love to trade, and you’ve set a goal to make a million dollars. You also wonder whether exchange traded funds can help you achieve that ambitious goal.
X Can ETFs in fact generate wealth in the same way that the best CAN SLIM-quality stocks can?
In some ways, the question is difficult to answer. ETFs simply don’t have as long a trading history as stocks. And even if some funds are concentrated in their holdings, one might think they cannot make as large a move as a highflying tech or the future Home Depot (HD).
Yet some ETFs are built with leverage, so they are designed to move at a similar tempo to high-growth equities. And when the market is favoring certain industry sectors, the right set of ETFs can be employed to take advantage of short, medium and long-term moves.
A look at some of the hot-performing ETFs lately should convince you that it’s worth the time and effort to focus your research on ETFs as serious moneymaking vehicles.
Consider the SPDR S&P Homebuilders (XHB), a liquid exchange-traded fund that currently trades on average 1.6 million shares a day. With a 27% year-to-date gain through Wednesday, the sector-type ETF is easily beating the S&P 500’s 17.4% advance.
When was a good time to buy XHB? The late-February breakout past 36.05 in a six-month cup with handle, a bullish chart pattern for stocks and ETFs that break out to new highs, was a prime spot.
In the cup portion, the ETF falls no more than 33% to 35% below its peak, bottoms out, then rises again. Ideally the rebound will show numerous instances of heavy turnover.
The handle formed over three weeks after XHB reversed from a 35.95 intraday peak on Jan. 26. The handle showed a gentle drop from high to low, sloped lower along its lows, and formed in the upper half of the cup. All good.
While volume was just so-so in late February, it picked up quickly on Feb. 27 when XHB rallied 1.5% to 36.38, as well as on March 1 during a 2.3% lift to 36.85. In both cases, shares were still in the proper buy zone.
Once XHB advanced past 37.85, or 5% above the 36.05 correct entry, it became extended and too far high in price to buy.
A more recent buy opportunity arrived at the end of September, when XHB rolled past a 39.32 buy point in an 11-week flat base.
How could an ETF trader make the most of these two short-term moves?
Several skills need to be mastered. First, you need to become comfortable analyzing charts and looking for clues of big demand. Second, check the strength of the sector. IBD’s stock research tables can help, since they rank 33 separate industry sectors based on multiple periods of relative performance. The top five sectors are generally going to be leading the market.
In the IBD Weekly for the week of Sept. 25, Building ranked No. 4 among 33 sectors.
Proper Position Sizing Is Key
Let’s say you have half a million dollars and want to turn it into a million. You cannot afford to be too concentrated in one ETF, but you also want to have a sizable position so that you can cash in a big gain when you are right.
So consider this strategy: In each ETF you trade, build a $62,500 position, which would represent one-eighth of your portfolio. A 20% gain on the position would score a profit of $12,500, boosting your portfolio account by 2.5 percentage points. Accumulate 40 such winning trades over time, and you’ve netted a half million in profits, minus your trading losses and commissions.
When it comes to buying the ETFs that represent traditional growth sectors such as retail, medicine or technology, you likely will do better when IBD’s current outlook points to a confirmed uptrend. Here, following the IBD ETF Strategy will be immensely helpful. Most stocks — and thus ETFs — will follow the general direction of the market. IBD Leaderboard features daily commentary on this strategy as well as an annotated chart of the Nasdaq composite, showing precise signals on when to go 100% long, cut exposure to 50%, and go completely in cash.
Don’t forget that some leveraged ETFs can produce unintended results if you hold them too long. Due to the mathematical nature of these funds, the long-term performance won’t necessarily match the index it tracks — especially those that are designed to act inverse to the equity index.
Last but never least, always keep your losses small in every trade. It’s human to make mistakes, and even the best traders in the world know they will make lots of errors. But the most successful traders, in ETFs or otherwise, will have an iron discipline in doing their best to let their big winners grow while never letting their losses exceed a set threshold — say, 7%-8% in a normal uptrend and 3%-4% in sideways or choppy markets.
(A version of this column was originally published on Sept. 30, 2016. You can trade the IBD 50 ETF (FFTY) by Innovator Capital Management. Also, follow Saito-Chung on Twitter for more insights on the stock market at @IBD_DChung.)