Understand the underlying

[pedro01]

All

Recently - on a thread who's name shall not be mentioned (OK - it was this one). A member put up a chart of an ETF.

Now - I do hold ETFs and am currently going through the process of exiting all of my mutual fund holdings to put into ETFs too. I also have a bit of an understanding of how the ETFs work.

The point I'd like to make is that traditional technical analysis or in fact ANY technical analysis breaks down when you look at some instruments. For ETFs, the instruments are exchange traded, you could actually quite easily pull one up on a stock screener & then start applying technical analysis.

The thread in question was about Natural Gas and an ETF that attempted to track gas was used to discuss where gas was headed. The concepts of S&R were mentioned as well as volume. Neither of which can be relied upon with a commodity ETF.

First of all, the volume represents people trading in the shares of the ETF. Unless the ETF presents a large portion of that commodities volume AND the ETF needs to issue new shares because of additional volume then the actual volume traded in relation to the price of the ETF is largely irrelevant. The moves of the underlying will move the ETF price regardless of ETF volume. It is the job of "Authorised Participants" to attempt to keep the price & value of an ETF in line.

Also - some ETFs do not buy the whole index that they track, they use sampling techniques which leads to tracking errors. By law, UITs are not allowed to re-invest dividend payments in stocks and therefore in bull markets, they will tend to lag. As such - the chart that you see on an index tracking ETF will not really be an ideal thing to use when looking for S/R, breakouts etc.

I just thought I'd mentions this because sometimes, a chart may not be showing you what you think it is showing you. Hence, I think it's always worth understanding the underlying instrument before going in on a TA driven trade.

Rant over.

Pete

 

[timsk]

Good rant, Pete.
As a little aside, when I traded U.S. stocks, I always had a chart of XLF open (The Financial Select Sector SPDR Fund) as it frequently gave an early 'heads up' and appeared, at times, to lead the market. Admittedly, this was at the height of the financial troubles this time last year, so things could well be very different now. Even so, in the event that I return to day trading U.S. equities and want to trade one of the financials, I would still look at XLF for confirmation before entering a trade. Anyone interested in finding out more about SPDR's, this is the place to go:
Select Sector SPDRs
Tim.

 

[pedro01]

Nothing wrong with that Timsk.

When these price disparities occur, the APs come in and place an arbitrage trades which narrows the gap. They can do this by issuing more ETF shares OR by buying the underlying. As with UNG a few weeks ago and GAZ now, they suspended the issue of new shares which meant the gap between the underlying value and the ETF price grew out of all proportion.

When new shares of UNG were not being issued. This caused the ETF price exceed the underlying by about 15%. When they started issuing new shares again, the APs stepped in and made their arb trades, the price dropped and the regular punter got his ass spanked. The move was nothing at all to do with the underlying value.

Note that ETFs track indexes - but an index doesn't have to be a traditional index like the Dow Jones & S&P int he way that most people think.

Indexes exist because people pay for a license to re-use them. So the SPY has to pay standard and poors a license fee for the index. The ETF provider cannot run the index on which the ETF is based. Hence the differentiation between ETF provider & Index provider.

So what does this mean ? It means there are thousands of indexes, many of them esoteric, with different weighting and selection methods such. Many indexes are created, not with a view to giving us a view to the market BUT with a view to making it easy for someone to turn into an ETF. For instance, a bunch of pesky illiquid instruments doesn't make a friendly index. Therefore, handle ETFs with care.

There are also different classifications of ETFs and ETNs with slightly different governing rules. All of this adds up to the need to understand them or face the possibility of having your pants pulled down in a big way.

If you'd just picked up UNG on your scanner the day before, there would have been nothing in the technicals telling you that it was going to move in the way it did.