Are there benefits to determining which sector ETFs are showing the most divergent trends? You bet!

UNLESS YOU'VE BEEN HIDING under a rock, you are familiar with exchange-traded funds (ETFs), but many are not aware of how many different families and types of ETFs exist. Years ago, most traders only paid attention to the broad-based ETFs such as (the S&P 500 Index), (Nasdaq-100 Index) and DIA (Dow Jones Industrial Average). Yet the ongoing creation of new ETF families has presented both traders and investors with new opportunities that are each suited to a different type of market condition.

When the major indexes are steadily trending in one direction or the other, the broad-based ETFs are an ideal trading vehicle. To profit in a smoothly trending market, one only needs to identify which of the broad-based ETFs are trending the best and then initiate positions in the direction of that trend.

However, non-trending, choppy days are far more common than trending days over the course of an average week. While choppy markets may be ideal for day traders who thrive on volatility, they present a challenge for ETF "trend traders" who do not look outside of the most popular "big three" ETFs mentioned above. Swing traders who attempted to profit from positions in SPY or QQQQ from mid-May through the end of June can attest to the challenges of range-bound markets.

Profit From Sideways Action
Fortunately, there is a solution that enables ETF traders to profit even when the broad market is not cooperating. In this article, I will share the basic concepts of a technique that our company uses to trade ETFs in all market conditions, but specifically in sideways, range-bound markets. Though the "big three" ETFs are likely to stop you out due to whippy action in a range-bound market, there are always a handful of industry sector ETFs that show divergent trends from the broad market. These sector indexes often will generate double-digit percentage gains even while the S&P and Nasdaq are mostly unchanged. If you can identify those sectors that are showing the greatest degree of divergence, you can subsequently enter positions in the ETFs that most closely correspond with the particular sector. To do so, though, you first must be aware of the various types of ETFs and the families to which they belong.

that mirrors the commodities futures price of spot gold.

All of these choices can be overwhelming, but focusing on the sector-specific ETFs provides plenty of opportunities in a variety of market conditions. There are many different families of sector-specific ETFs, with companies launching new offerings at a rapid pace, but here we solely focus on sector ETFs from three different families: HOLDRs, iShares and Select Sector SPDRs.

The Big Three Families
One of the most popular ETF families belongs to a group known collectively as HOLDRs, an acronym that stands for Holding Company Depositary Receipts. These securities represent ownership in the common stock or American Depositary Receipts (ADRs) of specified companies in a particular industry, sector or group. Issued by Merrill Lynch, there currently are 17 different HOLDRs. Of these, 15 track specific industry sectors, and two track broad market indexes. Though limited to just 15 industry sectors, many of the HOLDRs have high levels of average daily volume, causing them to be trader favorites.

Next, there are the iShares. Barclays Global Investors, the company that created the first index strategy in 1971, launched the iShares family of ETFs in 2000. iShares have gained popularity because the family consists of broad-based, industry sector, international and fixed-income ETFs. However, the less-popular iShares sometimes have wide spreads due to light average daily volume levels.

There are nine different sectors that comprise the Select Sector SPDR family of ETFs, which is the same company that brought you the first domestic ETF the S&P 500 Tracking Stock (SPY). Like the HOLDRs, the Select Sector SPDR family of ETFs is small, but they are quite popular nonetheless.

There are a total of 51 different industry sector ETFs between the three families discussed above, but we have narrowed this down to feature only the most popular ones in Table 1. Here we have all ETFs within the three families that have a 50-day average daily volume of at least 200,000 shares, in descending order. Notice also that, for one, the biotech sector has more than one major ETF tracking it.

Although Table 1 only lists ETFs with a high number of shares per day, don't get too obsessed with actual liquidity issues in ETFs. Unlike individual stocks, which you probably would not trade if the average daily volume were too low, remember that all ETFs are synthetic instruments. As such, you will notice that high average daily volume is less important for ETFs than for individual stocks. Why? Because potential price manipulation that one might typically see in low-volume individual stocks is not a factor with ETFs. The reason for this is simple: the price of an ETF, whether a HOLDR, iShare or SPDR will closely mirror the price of the underlying stocks that comprise it. Consequently, even if no trades are being executed in a low-volume ETF on a given day, the bid and ask prices will rise and fall as the prices of the underlying stocks change. Table 1 is limited to stocks with over 200,000 average daily volume only to give you an idea of which sector ETFs are the most popular.

Also take a look at the two separate "Avg. Daily Vol." columns in Table 1. The first column, "Avg. Daily Vol. (July 2005)," obviously displays the current average volume for each ETF, while the column to the right, "Avg. Daily Vol. (July 2003)," shows the average volume of those same ETFs only two years prior. Of the 24 ETFs listed in the table, only three have seen a decline in average volume from two years prior. All of the rest have seen a major increase in average volume 300-to-400-percent surges (or more) over the past two years. Consequently, these numbers confirm any general comments you may have heard about the recent growth of interest in ETFs.

Spotting the ETF Trend Divergence
After establishing which sector ETFs to keep on your daily watch list, the next step is to determine which ones are showing the most divergence from the broad market. The easiest way to do this is to create a "percentage-change" chart on your trading software that enables you to overlay each sector ETF with a chart of the S&P 500 (or Nasdaq if you prefer). The time interval of the chart depends on what type of trader you are. Day traders may prefer to use three- or five-minute intraday charts, while longer-term trend traders will use daily or weekly charts. Regardless of the time horizon you trade, the concept works the same. However, greater trend divergence that results in larger profit potential obviously will come from the longer time periods.

After scanning the overlay charts with each of your sector ETFs, you will quickly spot divergent trends. Obviously, we want to buy those sector ETFs with the most bullish divergence (relative strength) and/or short those with the most bearish divergence (relative weakness) to the broad market.

The sooner you spot the divergent trends, the less risk and higher profit potential for entering a new ETF trade. We have found the best way to catch divergent trends in the early stages is to become disciplined at scanning your overlay charts at a regular interval, depending on the type of trader you are. Because we are generally entering trades with a several-week to several-month time horizon, we scan for sector trend divergence no less than one time each week.

Those looking for sector ETFs with a bullish trend divergence need to pay attention to how the ETF acts on each move in the S&P or Nasdaq. Sector ETFs with relative strength usually will go sideways to slightly higher when the S&P or Nasdaq drops, but will rocket to new highs on the slightest bounce in the broad market. Conversely, short candidates should barely lift off their lows when the S&P and Nasdaq rallies, and should fall to new lows on any broad market weak.

Chart 1 is a weekly chart that compares the percentage changes of both the S&P 500 and (utilities HOLDR) from May 2004 through July 2005. As seen, UTH has outperformed the S&P by more than 400% during that period, but the important point is that UTH's bullish divergence could have been identified early in the trend. As the black vertical lines illustrate, UTH traded sideways to higher each time the S&P dropped for a several-week period. Then each time the S&P recovered just a bit, UTH zoomed to new highs. When you spot this type of divergence from your daily or weekly research, consider buying those ETFs and staying with the positions as long as the bullish divergence continues.

On the flip side, Chart 2 shows an ETF with a bearish trend divergence.The weekly chart compares the S&P 500 with PPH (pharmaceutical HOLDR) from May 2004 through July 2005. While the S&P has gained 11%, PPH showed bearish trend divergence and lost seven% during this period. Again, this trend divergence was noticeable in the early stages because PPH dropped at a much higher percentage rate than the S&P on the "down" weeks, but failed to recover with the S&P on the "up" weeks. From May 2004 to mid-October 2004, the S&P 500 was unchanged, but PPH had already lost 15% by that point.

Let the Trade Run
When you spot these divergent trends early enough, you simply can trail stops to maximize profits as long as the divergence remains intact. A long position in UTH combined with a simultaneous short position in PPH would have given you a gain of more than 50% within the past 16 months. Even if it took you several weeks (or even months) to notice the divergence, you still would have been entering early enough in the trend to realize a nice profit. Again, we emphasize that the same techniques work on much shorter time frames, even for day traders, but the divergence is often more clear on a longer time frame.

Another option for determining which sector ETFs are showing the most divergent trends is simply to sort the ETFs on your watch list by percentage change and note changes to the list each time you do scanning research. At the end of each week, we use a layout similar to the one in Table 2 to determine which sector ETFs have gained or lost the most relative to the broad market.

Of particular interest, notice the column in Table 2 labeled "% Range." In addition to simply plotting%age price changes each week, it's also helpful to see where each ETF closed the week (or day) relative to its range of that time interval. The closer each ETF closed to the top of its range, the more relative strength it is showing. Conversely, ETFs that close near the bottom of their ranges are showing the most relative weakness.

Realize the Benefits of Sector Trading
After getting in the habit of scanning all of your sector ETFs at a regular interval of your choosing, the divergent trends will become apparent. If the same ETFs are showing bullish or bearish divergence every time you do your research, a longer-term trend divergence that occurs from institutional sector rotation is probably taking place. Buying the sector ETFs with bullish trend divergence and shorting those with bearish divergence enables you to ride along on the coattails of institutions who also realize the benefits of sector trading with ETFs.