One of the time tested principles of market dynamics is the principle of the Reversion to the Mean. Over the long run, performance, volatility, price, relative strength: all of these measures mathematically require that periods of out-performance shall return to the mean. Naturally, this is not prediction, only an appreciation of how the math is performed. Nevertheless, it does allow for the trader to establish some shorter term trades that have very favorable reward to risk characteristics.
ETFs, by their nature as a composite trading instrument, are even more likely to exhibit the reversion to the mean behvioral characteristic than the stocks that individually compose the ETF. It is now a habit of mine to frame recent performance for a basket of ETFs in terms of the number of standard deviations they have moved away from their recent mean, and then look for the first signal of price evidence that the reversion to the mean has begun. I take that opportunity to see if I can frame a favorable reward to risk trade based on a stop at the recent turning point (the hypothetical end of the last swing) and a return to the mean. If I can get a 2:1 minimum, preferably 3:1, then I will take the trade, using the normal risk management and position sizong algorithms in the kit bag.
Today’s trade in Wachovia (WB) (though not an ETF) and last week’s trades in EEV (2x inverse emerging markets) and ILF the Latin American ETF are all excellent examples of this trade strategy.
What I like is that it does not require fundamental analysis (I dont have a trading edge there) and it reduces individual company risk by virtue of using the ETF. Example: today’s WB trade, since it is an individual stock, does not allow me to risk as high a percentage of my portfolio as I could with an ETF.
My current practice is to use a 180 day look back period for establishing “normal” and then considering 30 day look back periods for the current proprietary indicator reading to determine conditions of overbought/oversold. Using this screen and filter technique has been satisfactory for me.