In the last part of the series, we set out a basic overview of components that are needed for creating a trading system for shorting inefficient ETFs. In today’s work, I would like to focus on entry situations suitable for opening the trade.
There can be of course many entry signals for short.
- Actual market value
- The level of the underlying market
- Contango / backwardation on the underlying market
For example, lets take the entry signals to a short position for the ETF: UVXY, the conclusion can be applied virtually to any other ETF, only the underlying market will be, logically, different.
Current Market Value (UVXY)
Perhaps the simplest entry criteria is the current level of the market we trade. It is not so important whether we use this or that indicator or trend line to identify market overbought criteria.
E.g. When using the indicator RSI (14) and the exponential moving average – EMA (34), the chart may look something like this:
As a possibility to enter the trade, for example, we can consider situation where the price reflects from EMA and RSI drops below 50.
However, I personally prefer a model that takes into account the cause of the inefficiency – ie most frequently contango and its current development (for example, for ETFs linked to volatility it is contango for futures contracts of the VIX index, for ETFs linked to the price of natural gas it is the contango of gas futures, etc.).
The level of the underlying market – VIX
We have subjected the VIX market to many surveys and calculations, and statistically comes as the best the level of about 20 as the first possible entry level for long-term short, followed by levels 27 and 30 as a level where it is possible to enter to a trade with another tranche.
Contango / backwardation on the underlying market
I also encountered approaches when traders use the turn of underlying futures market from backwardation to contango in order to go short. It is not surprising, such entries are logic and the success rate of such signals is quite high, as documented in the following chart.
Generally speaking, entry signals are just a small part to a mosaic called trading system, and their role is sometimes too overestimated. On the other hand, a good entry according to the trading plan always pleases, it is only necessary to specify the method you will follow (or find your own) and include it in the trading plan.