Picking the best markets and vehicles to trade is a major part of developing your overall trading plan. A question which came in over the weekend speaks to that subject.
I am new toÂ trading and was interested in understanding how to select stocks or ETFsÂ that are suitable for trading.Â I have heard some people say that the leveragedÂ ETFs and inverse ETFsÂ might not make good trading vehicles but it would be helpful to understand the criteria that should be usedÂ to develop a short list for monitoring.Â I’m specifically interested in vehicles suitable for trading trends several days to several weeks in duration.
The best advice I can offer on this subject is to compare the performance ofÂ a collection of stocks and/or ETFs with different volatility characteristics in terms of your trading system or methodology. Some trading approaches are better suited to more volatility and others to less. Also, if one is trend trading, there is the question of drawdowns and how comfortable you will be sitting through the inevitable ones. Higher volatility stocks and ETFs will tend to produce larger draw downs than lower volatility ones.
As for how to identify the stocks and ETFs with different levels of volatility, I suggest using the Normalized Average True Range (N-ATR) indicator. This is something I wrote about in the May 2006 edition of Stocks & Commodities. I also talked about it in the latter part of this ATR article on Trade2Win. Basically, N-ATR is ATR divide by either the current close or an n-period moving average matching the look-back period of the ATR calculation. This lets you see ATR expressed as a percentage of stock price, making it directly comparable between different markets and instruments.
TheÂ upshot of all thisÂ is that you can use N-ATR to pick out the stocks and ETFs with higher or lower relative volatility. Generally speaking, the most price-active ones will have daily N-ATR above 2% – often times well above.
Of course you could come up with other criteria for selecting your stocks and/or ETFs. Volume could be part of the mix. For a swing-trading timeframe trend oriented approach, identifying stocks and/or ETFs that are trending in the longer-term timeframe could be part of the equation as well. There are loads of different screenable characteristics.Â It really depends on how you want to trade.
No matter how you ended up dividing up your stocks and ETFs, though, the bottom line requirement is testing, testing, and more testing.