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Trading Short-term Corrections in the Market

Trading Short-term Corrections in the Market
April 25
20:44 2012

The markets have enjoyed a strong run up since late 2011, so the mild correction in recent sessions is no surprise and a healthy breather. The SPDR S&P 500 Trust Series ETF (SPY) was down five days running, and by April 10 had a two-day relative strength index (RSI) value of less than 2. That is simply extraordinary for an ETF.

With the market so oversold, a rebound was clearly in the cards. It did not hurt that Alcoa (AA) opened first-quarter earnings season on April 11 with a positive surprise: better-than-expected revenue growth and earnings of $0.10 per share against a consensus projection of a $0.04 per share loss. Soothing words from the European Central Bank about Spanish sovereign debt helped as well.

So SPY signals that it’s time to buy the selling, and some positive news confirms that. How can you get in on the discount buying offered by this weeklong dip?

Certainly you can take the conventional course, which is to buy the SPY. However, there are some more powerful options available as well. A leveraged bet on the S&P 500 is the ProShares Ultra S&P 500 ETF (SSO). It will move 200% of the S&P 500’s change. Naturally, there are leveraged ETFs for other indexes as well.

Speaking of indexes, don’t forget that there are others besides the S&P 500. Although the equity markets in general will move very similarly—the Dow Jones Industrial Average is the most common exception because it is composed of only 30 stocks, all of them large-cap—certain indexes will behave slightly differently under certain conditions, which can make them preferable in specific trading scenarios.

The PowerShares QQQ Trust ETF (QQQ), for example, tracks the Nasdaq 100. The inclusion of such stocks as Apple on the Nasdaq 100 can distort the index, making its performance differ from those that don’t include it. (“Different” has lately meant stronger, given Apple’s powerhouse price performance.) Another example is the iShares Russell 2000 Index ETF (IWM). It is a small-cap index ETF, composed of the 2,000 smallest companies (by market capitalization) in the Russell 3000 Index.

If you don’t believe there can be a significant difference among market indexes, consider the year-to-date (as of April 10) returns of the three index ETFs we’ve just mentioned:

  • SPY: 8.29%
  • QQQ: 18.64%
  • IWM: 6.24%

Wow. Let’s have a round of applause for Apple, eh? But if we look at three-year returns, the picture changes slightly:

  • SPY: 66.80%
  • QQQ: 105.10%
  • IWM: 74.23%

Hmm. Post-recession, it seems the small caps had an edge over the large caps. This just goes to show that if you truly want to be an active trader, you adapt your strategy to the market conditions if you want to optimize your returns.

Of course, when you’re anticipating something besides a bounce off of a correction, there are all sorts of ETFs available. Had you predicted this correction, for example, you could bought inverse ETFs for any of the three market indexes we just discussed—or for that matter, leveraged inverse ETFs to bet even more strongly on the decline.

In short, the ETF toolbox is full of handy gadgets for most any trading strategy, and by no means is the ETF world limited to equities. So far in 2012, the best-performing ETF of them all is KOLD, the UltraShort DJ-UBS Natural Gas ETF, with a YTD return of 122.09%. And wouldn’t you know it, but natural gas just hit historic lows. Those ETFs, however, are a story for another day, and another article.

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