My apologies, I was been pretty quiet last week. I was on vacation and I failed to put enough articles in draft! I guess this is what happens when you take back-to-back vacations right after the Holidays!

So today, I’ll continue my series on trading ETFs using a moving average. Back in January, we explained what the moving average is with an example. Today, we will see how to use this technical analysis tool.

What is the purpose of trading ETFs using a moving average?

As you know, an ETF is a group of stocks or commodities created in order to replicate a specific index. It can be bonds, a stock market, a sector or simply a commodity (such as oil or gold). Since they are not guaranteed, ETFs are subject to fluctuations. As an investor, you want to capture the gains and avoid important losses. While this seems like a perfect trading fit, it is almost impossible to achieve since we don’t have a crystal ball. However, it is possible to use the 200 days moving average to predict important ETF movements.

Therefore, it becomes easier to capture ETF gains and avoid most of the losses.

A practical example of trading an ETF using a moving average

I’ll continue with my ETF example from the previous post and will work with a graph of the past 5 years of the SPY, an ETF following the US stock market.

SPY ETF Graph:

Trading according to the moving average is pretty easy. In fact, you have to follow 2 simple rules:

#1 Buy the ETF each time the ticker price crosses the 200 moving average in an up trend.

#2 Sell the ETF each time the ticker price crosses the 200 moving average in a down trend.

Trading ETFs has never been so easy, right?

So following the same graph, here is where you should have triggered a buy (green circle) and a sell (red circle):

As you can see, this technique allows you to capture most of the gains while avoiding most of the losses. But how come you can simply trade ETFs according to such a simple rule? While the technique is not perfect, here’s the reasoning behind it:

Understanding how to trade ETFs according to the moving average

The stock market can be compared to a huge stomach: it gets all kind of information and it tries to separate the good from the bad while digesting. Based on the moving average definition, it shows the average ETF price for the past 200 days. In other words; it shows the strong trends of the ETF. Therefore, if the ticker price at closing crosses the 200 moving average in a up trend, it confirms that the price is pushing strongly in a up trend. Hence, chances are that we are in a bull period.

Since there is a huge psychological factor in trading, trends are very important. When an ETF starts going up, it gathers more and more attention. Then, more investors buy it and the price keeps rising. It is the same thing when investors hit the panic button and start selling.

Going back to the graph, you will notice that this method would have helped you make good returns while avoiding most of the downfall. In the upcoming post, I’ll push the example a little bit further by providing a full ETF asset allocation model trading with the moving average.

Since I work in the financial industry, I get opportunities to speak to stock brokers and portfolio managers. Each of them have their little secrets (some of them are good, while some of them are very bad! Hahaha!). One of them is called moving average trading.

Market swings are giving you headaches? You don’t want to risk your retirement fund but you want to make more money than 3% with a 5 year certificate of deposit? Have you ever heard of moving average trading?

What is Moving Average Trading?

This is a derivative trading strategy from technical analysis. Moving average trading basically needs 2 data to work:

–          A Stock Chart

–          The Stock Moving Average

In order to show you how moving average trading works, I’ll take an example.  So let’s pull out the 5 year stock chart of SPY, one of the top US Market ETF. While I am using an ETF, you can use the moving average trading technique with any stocks.

ETF 5 Year Stock Chart

Ok… the chart alone doesn’t tell us much about what and when to trade… We can only acknowledge all the ETF fluctuations over the past 5 years. In order to know when we should be trading, we will need the 2^nd piece of the puzzle: a 200 day moving average.

ETF 5 Years Stock Chart Along With its 200 Day Moving Average

Just before we analyze the graph…

Let’s take a step back and look at what the moving average represents. The moving average is a statistical concept used to measure major trends in data. The moving average is usually used by technical traders. It helps trigger a buy or a sell action. You can use a moving average with the number of data points you want (10, 20, 30, 50, 100, 200, etc).

Moving Average Example

Lets say that you have 50 data points and you want to calculate the 20 days Moving average. You will take the data from 1 to 20 and make an average. This will be your first point. Then, you will take the data 2 from 21 and make another average. This will be your second point on the graph. You now take data 3 from 22 and so on. Along with your graph from 50 data points, you will also have a smoother line showing the current trend of your data; this is the Moving average.

What is the point of using the moving average while trading?

The moving average will replicate the trend of the stock you are following (the ETF in this example). Therefore, it shows when the stock is on a up trend or a down trend. As you may know already, there is a huge psychological factor on any stock market. Therefore, if you can predict the trend of a stock or an ETF, you will know when it is the best moment to buy or sell. While this sounds pretty magical, it is far more complex than some wishful thinking. However, the moving average added on the stock chart helps you determine what the major trend is.

Wait! How Do We Use Moving Average When Trading?

In an upcoming post (next Monday), I’ll explain how to use the moving average and provide a full example of how you can do it. So stay tuned to know how to use the moving average when trading

Last week, we briefly discussed how to build an ETF asset allocation within your portfolio. We also created a 2011Top ETF lists broken down in different asset classes. But knowing that you can build your portfolio with ETFs and knowing which ETFs are the biggest on the market does not ensure you are investing money correctly. Did you know that asset allocation is responsible for more than 90% of your portfolio return over a long period of time? This is why today I will display an ETF asset allocation model for growth investors.

ETF Asset Allocation Model Example

I believe that you don’t need many ETFs to build a solid portfolio. I also think that if you add more ETF, you are leaning toward diworsification instead of diversification ;-). The ETF asset allocation model I am presenting today is for aggressive investors. The purpose of such asset allocation is to generate growth overtime. This ETF model suits an investor perfectly if you are not afraid of market fluctuations and that you plan on investing over a long period of time (401(k) account for example).

SPY (US Market): 15%

EWC (CDN Market): 15%

EFA (Intl Market): 15%

EEM (Emerging Markets): 15%

VNQ (REITs): 20%

TIP (Bonds): 20%

Is the ETF Allocation Model That Simple?

This is actually the point; why should an ETF asset allocation model be complicated? ETFs were created to bring a new flexible opportunity for investors without having them pay high management fees. Now that the product has become so popular, you have too many choices. By sticking to the basics for your asset allocation (e.g. most influential stock markets + fixed income), you are sure to benefit from the markets without losing yourself in a 20 ETF portfolio.

This Allocation Model Should Be Considered Aggressive

As previously mentioned, this ETF asset allocation model is considered to be aggressive. Why? Because even if you are holding fixed income related investments (e.g. bonds and REITs), the problem is that you are not the shareowner of your fixed income. Therefore, ETF bonds and ETF REITs follow the market value of the underlying assets. You will earn interest or dividend income, but you are not the beneficiary of any guarantee. Since you have no guaranteed investment in this model, the portfolio should be considered aggressive.

The ETF Asset Allocation Model Should Be Combined With Bonds or CDs

If you prefer taking less risk in your portfolio, you can also combine this ETF asset allocation model and some government bonds or certificates of deposit. I know that the latter are far from being sexy investments as their interest rate are very low these days but it can bring some stability to your portfolio. In the event of an interest rate hike, your bond ETFs will drop as well as the value of the individual bonds in your portfolio. The difference is that you know that if you wait until maturity, your individual bonds will be paid completely without any capital loss.

Final thoughts on my ETF Asset Allocation Model

Do you like it? Do you think I have forgotten an asset class? What does your asset allocation look like at the moment?

As previously mentioned in my introduction post on ETF Asset Allocation, I discussed 2 ETF investing approaches; the micro and macro asset allocations. Today, I want to dig further into the macro investing strategy as I think you can setup a great ETF portfolio with a lazy management asset allocation technique. This won’t require much of your time while you will be able to:

#1 Follow the market

#2 Make money over time

#3 Optimize your fee structure

#4 Build a solid asset allocation

#5 Use few investment tools (only a few ETFs)

ETFs To Be Included In Your Asset Allocation:

While I won’t tell you which ETF to buy or to trade (I’m not making any recommendations on ETFs nor on your asset allocation), I made a list of ETFs covering specific markets along with a some information to help you make your own decisions. Remember that all ETFs are traded on the US market.

ETF US Market

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ETF Canadian Market

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ETF International Market

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ETF Emerging Market

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ETF Real Estate (REIT)

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ETF Bonds

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Why Not Add Commodity ETFs to Your Asset Allocation

That is definitely a personal choice but I would rather use a Canadian ETF instead of a pure commodity ETF in my asset allocation. Why is that? Because almost 40% of the Canadian market is represented by commodity related companies. They have oil, gold, silver… you name it! On top of that, the Canadian market has a strong economy and shows great potential for the future. This also smoothes the volatility of a portfolio as pure commodities in your asset allocation will definitely increase the variations.

Another personal reason why I don’t like commodity ETFs is because investing in commodities is pure speculation. A bar of gold never produces a single dime of income. Investors consider commodities in their asset allocation based on the speculation that the price for resources will surge. I prefer going with a Canadian ETF. If you are looking to play with currencies at the same time, you might want to consider XIU, a Canadian ETF following the Canadian market.

But if you really want to include commodities in your ETF asset allocation, here’s the table of the top ETF in that category:

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6 ETFs and Your Asset Allocation is Over

This sounds almost too good to be true isn’t? In next Monday’s post, I’ll discuss more about how to adjust your ETFs in order to get the right asset allocation for you. As you can see, building a solid ETF portfolio can take only a few minutes.

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As with many investors, I like trading ETFs. This is probably the most flexible investment product you can find on the stock market. And I guess this is probably its biggest disadvantage too; you have so many options that it is hard to build your ETF asset allocation within your portfolio. It’s like being a kid in a toy store; you want it all but in the end, you won’t be able to play (handle) with all those toys. John Brennan, CEO of one of the biggest ETF manufacturer Vanguard, even said that the ETF market has become dangerous for the investor. This is why I wanted to discuss asset allocation with ETFs.

ETF Asset Allocation Micro Version

I think you can look at ETF asset allocation with 2 theories which I call the micro and macro approaches. The micro approach will encourage an investor to pick specific sector and buy ETFs according this strategy. The US market is well diversified and has great companies in many industries. You can easily build an ETF portfolio by choosing a few sectors that you believe they will outperform the overall market. For example, the financial and techno sectors have indications they may outperform the stock market in the upcoming years in my opinion. As well, you can decide to ignore other sectors in order to “optimize” your asset allocation.

I know that there are investors who think they can beat the market by selecting specific ETF sectors instead of going with indexes for example but I don’t agree with them. Most of the time, when an investor beats the market over 1 or 2 years, he will make an important mistake later on that eats-up past performance. Therefore, it’s hard to find someone who beats the market over a long period of time such as 10-15 even 20 years. This is why I would rather use an ETF asset allocation based on a macro model.

ETF Asset Allocation Macro Version

I like using a macro approach when establishing an ETF asset allocation. It makes my life as an investor much easier as I only care about the global asset allocation instead of adding time and energy on researching the “supposed” best sectors in the upcoming years. I think that following markets and indexes will produce a better return overall. However, then again, the numerous ETFs in each categories makes choosing the right asset allocation difficult. Here’s a quick list of my favorite markets to follow:

US Market

SPY, IVV, QQQQ, VTI, IWM

Canadian Market

EWC, XUI (on Canadian Market)

International Market

VWO, EFA, FXI (China), EWZ (Brazil), VEU

Real Estate (REIT)

VNQ, IYR, RWR, RWX, URE

Bonds

TIP,LQD,AGG,BND,CSJ

We could easily add several other asset classes or specific ETFs to this small list but adding too many rhymes with complicated ;-).

Considering Commodities in your ETF Asset Allocation

In the ETF asset allocation with a macro approach, I suggest to look at natural resources as a whole. Some people will disagree and prefer to hit specific commodities. We all know that oil was very popular between 2003 and early 2008. Now, the “flavor of the moment” is the yellow metal. In 2011, I believe that we will have a growing interest in silver and uranium. Silver being undervalued compared to gold and uranium represents a great energy alternative to oil.

What About ETF Currency Asset Allocation?

As I mentioned before, we can never stop adding other categories to an ETF asset allocation. Another mainstream issue is the weakness of the US dollar. In order hedge your portfolio against it; some people will use a currency ETF in their asset allocation. Following the Canadian dollar seems like an interesting move at the present time. Considering their economic strength (compared to the US) along with the humongous amount of natural resources on their territory, the loonie might climb past parity with the US dollar for a few years.

More thoughts on ETF asset allocation in your portfolio

In the upcoming post, I will make a list of some ETFs that can be traded in your portfolio in order to balance your asset allocation according to your needs. If you have any questions or requests, please feel free to comment ;-)

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