7 Rules for Day Trading ETFs2015-06-24
ETFs have been embraced by buy-and-hold investors and active traders alike for their unparalleled ease of use and cost efficiency. Short-term opportunities with lucrative risk/reward ratios often appear in the marketplace, however, only the savviest of traders take advantage of them and profit on a consistent basis.
Below, we highlight seven trading tips that all ETF day traders should have in their personal rule book if they want to increase their chances of success.
1. Write Down Your Trading Rules and Actually Follow Them
Easier said than done. Most traders fail because they don’t have a trading system in place that keeps them disciplined. Trading rules define how to find trade candidates, execute strategy, take profits and cut losses. Making trades based on guesses, emotions or random strategies is simply gambling. Use a well thought out and tested trading plan instead. Most traders “know” they should make a trading plan, but actually creating one and following it—the “doing”—is the most important part [see How To Swing Trade ETFs].
2. Know When to Stay on the Sidelines
Knowing when to sit out is just as important as knowing when to trade. Having a well-defined trading plan will tell investors when to trade and when not to trade. Market environments constantly change from ranging to trending, sedate to volatile. Are you equipped with the strategies and discipline to trade profitably in all of these environments? Are you able to determine when the environment is shifting? If not, there will be times you must sit on your hands. Investors must avoid the impulse to trade, only doing so once an established strategy is in place.
3. Don’t Try to Pick Tops or Bottoms
When investors start thinking they can predict price tops and bottoms, their trading gets very expensive. Traders refer to calling a bottom as “catching a falling knife” for a reason; it’s impossible to pick a bottom as the price is falling. It will likely run through and strip your account. Trying to pick a top in a strong market is no different. When looking to establish a short position after a strong rise, investors should stay away from assuming they know where the top will be.
Trying to be the first trader into a move is a losing battle. Let the market show a reversal is underway, creating a lower price high in the case of downside reversal, or higher low in the case of upside reversal, for example, before establishing a position. It’s not necessary to be the first trader in, or the last one out, to make a profit [see also Free Report: How To Pick The Right ETF Every Time].
4. Is Your Market Open?
Think fewer participants makes for easier money? Think again. When trading commodity or currency ETFs, make sure the underlying market is open. According to Horizons Exchange Traded Funds, a major ETF provider, you may not be getting a fair price otherwise. ETFs are linked to the underlying asset by a calculation called NAV, or Net Asset Value; but when the underlying market is closed, the ETF can deviate significantly from this “fair value” due to limited liquidity and wide bid-ask spreads.
It is important to note that even during normal market hours the market price of an ETF may fluctuate around its NAV value.
5. Have an Exit Plan
Investors would be wise to define the exact levels at which they’ll start to take profits or cut their losses. An exit plan should be covered in an investor’s trading rules, but it deserves reiterating. Without an exit strategy we become emotional, letting losses mount or profits slide away. Since it’s impossible to predict exact tops and bottoms (see rule #3), simply choose in advance how you will exit losing and winning trades.
Trade your plan; take profits or cut losses at pre-established levels or with a personally tested strategy such as trailing stops, Elliott wave theory, Fibonacci levels or other indicators [see ETF Call And Put Options Explained].
6. Tame Your Emotions
Emotions are inevitable; we all have them. Don’t try to avoid emotion, but rather learn which emotions affect your own trading and adopt a plan that accounts for those tendencies. Panic, fear, and greed are common, as well as boredom during quiet markets. Whatever your tendency, admit to it and then plan for it. For example, if you get bored and want to start making undisciplined trades, have a demo account open into which you can channel your destructive trades, or play solitaire during quiet times.
Investors struggling with greed or fear, deviating from the plan, can use software to set up automatic entry and exit orders (make sure you’re trading high volume ETFs). Don’t ignore your emotions (that’s impossible), but be aware that they will arise at inopportune moments, and plan for them instead.
7. Review Your Action
Take time to review your closed trades, both winning and losing. Don’t judge yourself on whether you were profitable or lost your shirt. Judge yourself based on whether you followed your plan. If you didn’t follow your plan, your results are random and mean nothing over the long run. If you did follow your plan, then judge the plan on whether it works or doesn’t based on profitability and other performance metrics. Adjust your plan accordingly [see also 25 Things Every Financial Advisor Should Know About ETFs].
The Bottom Line
Markets are in a constant state of flux between trending, ranging, choppy, volatile, and sedate. Take time to write down how you will trade (enter, exit and manage trades) in each of the conditions in which you choose to trade. Follow your plan and realize there will be periods when you should avoid trading. Don’t pick tops and bottoms, and make sure your ETF has adequate liquidity during market hours to satisfy your trading style. Know the emotions that affect your trading, and plan for them. Finally, be honest with yourself and constantly evaluate your plan and yourself. If either are not working, stop trading until you come up with a way to overcome the obstacle.
Disclosure: No positions at time of writing.