Thanks for sharing your interesting insight tradesman. The part I do agree with is that it is important to look for a big enough move where paying an extra 20 cents or so does not matter. If I am scalping and only looking to make a quarter, the spread matters a lot. However, we typically are trading the SPY with anywhere from 1 - 3 points profit target, so the spread becomes less of an issue. One other issue that I think traders sometimes forget is the importance of varying your position size with the beta or volatility of the ETF. I would never trade as many shares of SPY as I trade of QQQ because of the difference in volatilty. I use my position size calculator that I developed in Excel for determining ideal share size. I have also found that using ISLD for executions greatly helps decrease slippage on both sides of the transaction. However, I will use a limit sell or buy order on AMEX near my target price if there is momentum in the ETF because that typically results in getting better fills than is possible even with the ECNs. If there is a day when the S&P or Nasdaq is chopping around in a trading range, the solution is simple.. .don't trade SPY or QQQ. On those days, we either sit patiently in cash or we trade specific market sectors (usually HOLDRs) that are showing relative strength or weakness to the market.
Yesterday was a perfect example of why we always use the 20-minute opening gap rule before entering a trade that has triggered due to a gap down. The 20-minute opening gap rule states that whenever a trade immediately hits its trigger price due to a gap up or gap down on the open, we only enter the trade if it subsequently sets a new low or new high beyond its range of the first 20 minutes. The reason we have this rule is because a majority of gaps (both up and down) fail going into the first reversal period, which usually occurs within the first twenty minutes of trading. The rule prevents us from entering trades at the low or high of the day and quickly getting stopped out due to a quick reversal. Although the rule will sometimes cause us to miss a profitable trade, a majority of the time it prevents us from losing money, which is much more important. One of yesterday's plays was to short MDY if it traded below 80.40. However, I also reminded everyone to use the 20-minute opening gap rule. MDY triggered immediately on the open with an opening price of 80.10. During the next 20-minutes, MDY (and the broad market) consolidated at the lows, but only traded about 5 cents lower than its opening price. At exactly 9:50, the market began rallying hard and continued to do so for most of the day. MDY never traded below its opening 20-minute low and rallied all the way to over $82. If we did not have our gap rule in place, that would have surely become a losing trade. Instead, we simply never entered the trade. This is why it is important to always have an opening gap rule that you follow. Given the fact that both the S&P and Nasdaq closed well off their intraday highs, today could be very choppy or rangebound. Most importantly, I expect volume to be very light today, as many traders will be taking the day off to create a synthetic 4-day weekend. Remember that light volume enables the market to get whipped around easily because of the lack of big money on both sides of the market. I'll be posting part II of getting efficient ETF order executions on this thread over the weekend. Have a good holiday everyone.
IMHO there is no need to adjust the share size bacause it doesn't matter, no one I know ( there might be someone out there) has the legs to bounce the SPY in any real direction through size, the specialist will call you on it every time. I don't much care about the volatility either because even on a dead day the SPY is going to move 1.40 and that's enough for me. I believe (from watching the last prints of the day) that the specialist carries from 17,000 to 25,000 shares at any given second and will suck up and profit from any extra "volatility" that's not called for by the futures. Consistency is the key here and a 1.40 minimum daily move can get me in and out every trading day, not just the volatile days. I usually bid by splitting the spread plus a penny. I can put 5k on the book in quiet periods and get filled within a minute 90% of the time.
Tradesman, Perhaps I didn't clarify my post regarding adjusting position size. I was referring to adjusting position size purely from a risk management point of view. For example, buying 1000 shares of DIA is much different than buying 1000 shares of QQQ because you have almost four times as much capital exposure with an equal number of shares of DIA. Instead, I base my position size on a maximum dollar amount I am willing to lose per trade, which correspondingly dictates my maximum share size. It sounds like you have a style that works for you and that is excellent! I don't think you should change a thing. Just wanted to clarify for anyone else who might be reading this.
You said "One other issue that I think traders sometimes forget is the importance of varying your position size with the beta or volatility of the ETF." I was addressing volatility. I didn't know you meant capital management because you didn't refer to it anywhere in your post. Either way thank you for your blessing on whether or not I should "change a thing". I feel so much better now that you have blessed my trading plan. I'm sorry though I can't bless yours. Complication leads to losses. The best traders have a simple plan that works consistently. During the past few years two types of "traders" have evolved, those who trade and those who try and sell maps to the trading gold mine. Personally, I wouldn't care how many maps get sold except I detest the fact that new traders are being led astray by "the trend is your friend and volatility matters" nonsense. Trends change on a dime and volatility disappears once the news flashes or the fund gets filled.
I dont know why anyone is wasting there time with the specialists when trading the spy's - the real market is ISLD - but I agree, in momentum you can use the specialist to your advantage !!!!
I want to share my experiences and ideas for what I have found to be the best type of order to place and the most efficient method for routing your ETF order. This is the second part of the article I posted last week on getting efficient ETF order executions. Throughout this article, I have made the assumption that you have a brokerage firm who offers you a choice in how you route your order (primary market, third market, or an ECN such as Island). However, if you have a web broker who simply executes your order without the ability for you to choose the best route, there are still some ideas contained within that will assist you in getting better prices on your order fills. Market or Limit? As a general rule, I use market orders for executing both buy and sell orders. My philosophy on this is simple -- It's better to get a bad fill and catch an 80 cent move in your direction than to miss getting filled by 5 cents and watch the trade go run 85 cents without you in it. Remember that I am typically looking to make 1 - 2 points of profit from most trades I enter and am usually in the trade for anywhere from 1 - 3 days. I don't trade with the intention of profiting from nickels and dimes, so I also don't worry about them when trying to get filled on an order. This is a lesson I have learned from my mistakes of the past when my insistence on getting a good fill continually caused me to miss substantial profits. I soon learned that being stubborn by using tight limit orders is not as profitable as simply trying to get an average-priced execution over the long-term. I know some traders will disagree with me, but this is what I have learned the hard way through years of personal experience and it is what works best for me. All that being said, there are indeed some instances when I do use limit orders on ETF trades. The biggest factor that determines when I use limit orders is the liquidity of the actual ETF because some trade with much tighter spreads than others. In general, the more liquid a particular ETF is, the more likely I am to use a market order. Since high liquidity ETFs generally trade with a spread of only one to five cents, I usually get good fills with market orders and don't have to worry about chasing the price for pennies. However, when an ETF is illiquid, the spread will typically widen in correlation with the reduced liquidity. In those cases, I prefer to use a limit order. There are presently 21 ETFs that trade an average daily volume of 300,000 shares or more, which constitutes the entire realm of securities that I trade. However, there are 10 that I frequently trade. The list below shows whether I usually use market or limit orders on those 10 ETFs. There are always exceptions, but this list constitutes the type of order that I use a majority of the time: Market Order QQQ SPY DIA SMH Limit Order RTH MDY XLF OIH PPH BBH With the less liquid ETFs that I have listed above, I have found the best strategy is to place your order either slightly above or below the middle of the spread, depending on whether you are trying to buy or sell. If I am buying, I place my order about 5 cents above the middle of the spread and place it 5 cents below the middle of the spread if selling or selling short (remember there is no uptick rule). For example, let's assume I am trying to buy BBH when the best bid is 83.20 and the best offer is 83.80. Assuming it is not a fast-moving market, I would probably place my limit buy order around 83.55. However, in a fast-moving market, I would place my order a little higher, maybe even go with a market order if I felt confident it was about to run a few points. Remember my goal is not to catch every single cent of a move, but just to catch a good piece of the move with minimal risk. Order Routing There are basically two choices with regard to how to get your order filled. The first choice is through a stock exchange such as the American Stock Exchange (AMEX) or the New York Stock Exchange (NYSE). The other option is to place your order through an ECN (Electronic Communications Network). For those of you who don't know, an ECN is simply an electronic network of computers that allows traders to trade directly with one another instead of via a stock exchange. This results in faster, and usually cheaper, order executions. The ECNs that trade the most ETF volume are ISLD, REDIbook, and Instinet. Because of the speed of execution, I generally prefer to use an ECN for order execution. If I am trading QQQ, SPY, or DIA, I usually execute on Island. In fact, Island is rapidly becoming the standard execution choice for most traders who trade any of the ETFs. As of the time of this writing, Island trades 36% of the average daily volume in QQQ. This represents more than the combined percentage of both the NYSE and the AMEX! Island also executes approximately 33% of DIA volume and 25% of SPY volume. Although ECNs offer the fastest and most reliable method of execution, I have learned that there are times when executing your order through the AMEX is more profitable than through an ECN such as Island. When an ETF has been trending all day and it suddenly reverses direction, you will notice that the inside market for Island and the other ECNs rapidly changes. However, due to the slowness of the specialist system, it often takes the specialist longer to update his inside market prices than it does with an ECN. You can use this lack of speed to your advantage if you need to get out of the position by immediately placing a market order to close your position. Although there are going to be times when you occasionally get a bad order fill, I have found that I usually get a better fill through this method than if I would have joined the inside market on an ECN. More importantly, I am assured of getting out of the position. The most recent example of this happened to me last Thursday when I was short SPY before the big morning reversal. As soon as the S&P Futures spiked up, traders on ISLD immediately jumped above the inside offer of the AMEX, creating a crossed market. I knew that if I executed on Island, I would have paid up quite a bit. So, I placed a market order to buy on AMEX and got filled at a price that was at least 10 cents better than what I would have paid if I executed through Island. This has happened to me on many occasions, but primarily as soon as a market has reversed directions and the ECN traders have created a crossed market. On a final note for those of you that have access to Level II quotes, I strongly recommend setting your Level II box to highlight the AMEX, as opposed to NYSE because AMEX typically leads the market with most ETFs. You will often notice that the third party exchanges such as BSE, CIN, PHS, CBO, and NAS are slow to update their quotes and often will show an inside market price better than AMEX or NYSE. However, you will rarely get filled at those prices. Although NYSE is the big daddy in the world of stocks, I have found they are rarely on the inside market of most ETFs. Instead, AMEX leads the inside market because ETFs are issued on the AMEX. Therefore, with regard to the two biggest exchanges, you will typically get a better and faster fill with AMEX than through NYSE when it comes to executing ETFs. Bear in mind, however, the exact opposite is true when executing a traditional stock of just one company. You can reference the archives on our web site to read previous educational articles we have published on ETF trading. My major project this month is to analyze the components of each ETF that we trade so that you can learn the inner workings of them. By understanding which individual issues comprise each ETF, it will make you a more efficient ETF trader. You may want to subscribe to this thread because I will post all my ETF analysis here as it is completed. Hope this article has been of assistance.
Deron, A lot of traders use the futures and ETFs as leading indicators in their stock trading. Would trading the ETFs then (or futures) put you at a disadvantage since you don't have a leading indicator for these instruments? Thanks.
Actually, we do indeed have leading indicators. The leading indicators we follow are the actual sector indexes. For example, if trading BBH, we follow the BTK index. If trading SMH, we follow the $SOX. The sector indexes tend to lead the respective ETFs by a few seconds, even creating occasional arbitrage opportunities as well. In addition, we follow both the S&P and Naz futures. There is an article on this thread that I posted entitled "Getting Efficient ETF Executions Part I - Follow The Index." I think it is back a few pages on this thread. You may want to read that article because it discusses more details of following each ETF's respective index.