Copyright 2015 ETF Dynamics, LLC

The US Securities and Exchange Commission (SEC)

Requires the following legal notices:
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Copyright 2015 ETF Dynamics, LLC Page 1

 TABLE OF CONTENTS

Introduction to ETFs Page 3

Understanding Leveraged ETFs Page 4
ETFs versus ETNs Page 6
Advantages of Trading ETFs Page 7
Pitfalls of Trading Leveraged ETFs Page 8
Our Criteria for Selecting ETFs Page 9
Our Favorite ETFs Page 10
A Divergence Strategy for ETFs Page 12
Stop Loss and Exit Strategy Page 23
ETF Resources Page 31

Copyright 2015 ETF Dynamics, LLC Page 2

 Introduction to ETFs

The popularity of Exchange Traded Funds, or ETFs, has grown dramatically in

recent years. At the end of 2014, over thirty percent of total daily market volume was
generated by ETFs. More than 1,700 ETF products are currently trading, encompassing
major indexes, individual sectors, overseas markets, commodities, currencies, and
bonds.
Twenty years ago, only a handful of what are now referred to as ETFs existed. The
original index tracking stocks, known as SPDRs, were launched in 1993. These
instruments were designed to track the percentage returns of the major indexes, and
included the SPY for the S&P 500 and the DIA for the Dow Jones Industrial Average.
The big change for the ETF market came in 2006 when the SEC approved active
management of ETFs. This allowed ETF managers to use derivatives to gain leverage in
ETFs, and rebalance the instruments used for that leverage on a regular basis.
The world of ETFs has opened the door to markets, sectors, and commodities that
retail investors might not otherwise have access to. Leveraged ETFs present the
opportunity for greater returns over a short period of time. Despite the popularity of
ETFs in recent years, theres still some confusion as to how they trade.
ETFs are investment funds that trade on a stock exchange as a tracking stock for an
underlying index, sector, commodity, currency, or bond. ETFs trade on the major
indexes just as any individual company stock would. The vast majority of retail brokers,
both traditional and on-line, offer access to ETFs. The investor/trader places an order
for a specific ETF in the same way any other stock order is placed. Commissions at the
vast majority of brokers are the exact same as they would be for any individual stock
such as GOOG (Google common stock) or MSFT (Microsoft common stock). ETFs can
also be traded in retirement accounts such as IRAs and 401Ks.
The major difference between trading ETFs and individual stocks at most brokers is
that leveraged ETFs may have more stringent margin requirements. The higher the
leverage is for an ETF, the less margin an investor is typically allowed to use to purchase
that ETF. Some brokers may have additional regulations for leveraged ETFs, so please
check with your broker to find out their specific restrictions.
In addition to bull ETFs that follow the price movement of an index, inverse or
bear ETFs are designed to move in the opposite direction of the index. These
instruments allow short exposure in retirement accounts that prohibit short sales of
stocks. By taking a long position in a bear ETF, the investor is the equivalent of
being short the underlying index. The inverse ETF should rise if that index declines.

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 Understanding Leveraged ETFs

Leveraged ETFs have become increasingly popular in recent years. Many of these
ETFs are highly liquid, fast moving, and offer the potential for substantial gains. They
can also result in substantial losses for a number of reasons that well examine
throughout this eBook.
Leveraged ETFs operate in a considerably different manner than conventional,
unleveraged Exchange Traded Funds. These differences need to be carefully understood
by investors.
Leveraged ETFs are designed to double (2x) or triple (3x) the daily moves of the
underlying index. This is a critical point to understand since over a period of more than
one day, a leveraged ETF could return more or less than the underlying index.
Over a long period of time, this has a compounding effect that can either improve
gains or magnify losses more than the 2x or 3x rate that an investor would expect. This
is due to daily rebalancing which is required to maintain the funds goal of daily returns
of 2x or 3x the movement of the underlying index.
To illustrate this point, well look at the performance of Russell 2000 ETFs over a
four year period. The first column is the IWM, the unleveraged ETF for the Russell 2000
which tracks the underlying index almost perfectly. The second column shows what 3x
leverage should return based on the percentage change in the IWM. The next column
shows the returns over the same period of time for the TNA, the triple leveraged bull
ETF for the index. The final column shows the returns of the TZA, the triple leveraged
bear ETF for the Russell 2000. As an inverse ETF, the TZA should rise when the
Russell 2000 declines.

IWM 3X TNA TZA

2011 -4.44% -13.32% -38.10% -43.46%
2012 16.69% 50.07% 42.63% -49.90%
2013 38.69% 116.07% 146.48% -68.58%
2014 5.04% 15.12% 5.20% -29.29%

In 2011, the Russell 2000 lost 4.44% for the year. While the 3x loss should have
resulted in a decline of 13.32%, the TNA actually lost 38.10%. At the same time, the
triple leveraged TZA bear ETF lost 43.46% for the year instead of rising 13.32% as would
be expected if it had properly tracked the index with inverse 3x leverage over a long
period of time.
In 2012, the TNA failed to gain the 3x 50.07% of the IWM, instead rising only
42.63% for the year. But in 2013, the TNA rose far more than the 116.07% that a 3x
return should have brought. In both of those years, the bear TZA fell less than 3x the
amount of the Russell 2000.

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 In 2014, the TNA rose essentially the same percentage amount as the index, ending
the year well short of a 3x return. The TZA lost almost twice what the inverse 3x amount
should have been over that same period of time.
Even on a daily basis, there can be a noticeable discrepancy between what a
leveraged ETF should return based on the move of the underlying index and what the
actual return is. Supply and demand in the open market can play a role in this. Its not
uncommon to see a 3x ETF gain more than the expected daily return on a day with a
strong directional move in the underlying index.
Direxion, an issuer of many popular leveraged ETFs, issues the following warning
on their website regarding the Exchange Traded Funds they operate:

These funds are intended for use only by sophisticated investors who:
understand and accept substantial losses in short periods of time;
understand the unique nature and performance characteristics of funds which
seek leveraged daily investment results; and
have time to manage positions frequently to respond to changing market
conditions and fund performance
These funds are not intended for use by conservative investors who:
cannot tolerate substantial or even complete losses in short periods of time;
are unfamiliar with the unique nature and performance characteristics of funds
that seek leveraged daily investment results;
are unable to manage a portfolio actively and make changes as market
conditions and fund performance dictate.

The end result is that most leveraged ETFs are designed as short term trading
instruments as opposed to long term investment vehicles. Positions in leveraged ETFs
should always be monitored on a daily basis. If youre new to the ETF market, please be
aware of the risks and realities of trading leveraged ETFs.

Copyright 2015 ETF Dynamics, LLC Page 5

 ETFs versus ETNs

In addition to ETFs, many indexes, sectors, or commodities also have ETNs, or

Exchange Traded Notes. ETNs trade in the same manner as ETFs, but are different in
structure. ETNs are issued as senior debt notes, while ETFs represent equity positions in
the underlying index, sector, or commodity.
ETNs track their underlying indexes minus an annual expense of 75 basis points per
year. Unlike ETFs, there are very few tracking errors with ETNs. Like ETFs, there are
leveraged and inverse ETNs.
ETNs possess credit risk, so if the issuer goes bankrupt, the investor may not receive
the return he or she expected. An ETF, on the other hand, has virtually no credit risk,
but there is tracking risk involved with holding an ETF. As we examined in the previous
section, there is a possibility that the ETF returns will greatly differ from the underlying
index. From a short term trading perspective, however, there is very little difference
between an ETF and ETN.
Popular ETNs include the VXX which tracks the S&P 500 Volatility Index, the DJP
for the Dow Jones-UBS Commodity Index, the DGP, a 2x leveraged gold ETN, and the
INP which tracks the MSCI India Index.
Depending on your individual tax bracket, ETNs may be taxed differently than
ETFs. You can read more about the differences between ETFs and ETNs in this article
from Investopedia. Please note that we are in no way associated with Investopedia and
provide this article only as a courtesy to our clients.

Exchange Traded Notes by Investopedia

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 Advantages of Trading ETFs

If you dont currently trade ETFs, there are many advantages to adding them to your
trading portfolio. The first is that ETFs provide exposure to a broad range of indexes,
sectors, and commodities for the same cost as trading stocks. The range of leverage
available in todays ETFs allows investors to select a trading product based on individual
risk tolerance as well as investment goals.
For the long term investor, ETFs provide access to foreign market indexes for the
same price as buying a stock listed on US exchanges. Prior to the introduction of ETFs,
overseas mutual funds with expensive management fees were really the only way to
invest in foreign markets.
ETFs also allow access to commodities, currencies, and bonds without having to add
an additional trading platform, account, or special charting service. ETFs have made
virtually any investment instrument available in todays markets accessible to the retail
trader through their existing brokerage account.
In the case of many ETFs, the stability of an underlying index wont be as affected by
news as an individual stock can be. Individual company equities are prone to sudden
large gaps based on news. When that news is negative, the gap down in an individual
stock can be substantial. However, although the ETF for a major index may fall if a
component has bad news, the rest of the index can buffer the loss, even in leveraged
ETFs. Its also important to note that ETFs cannot be halted due to news in the way an
individual company stock can be.
One of the greatest advantages to trading ETFs is that they allow short exposure in
retirement accounts that otherwise dont allow short sells. By taking a long position in
an inverse ETF, the investor should profit from that bear position if the underlying
market falls.
ETFs allow investors to utilize margin for long term investments in commodities.
For example, if an investor wants a long term position in gold, a gold ETF can be
purchased on account margin without having the cash expense of buying physical gold.
When compared to other leveraged instruments such as options or futures, ETFs
have very low costs associated with their trading. Most retail brokers charge a flat fee for
unlimited shares of an ETF that is the exact same as the commission would be for any
other stock.
The increased popularity of ETFs has resulted in highly liquid trading instruments.
Leveraged ETFs provide the potential for substantial intraday and short term price
movement with consistent volume and limited slippage. Although the risk is greater
with leveraged ETFs, so is the potential return on a short term basis.

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 Pitfalls of Trading Leveraged ETFs

While there are many good reasons to trade ETFs, there are a few pitfalls that
investors should be aware of. As we previously discussed, there is always the risk that
leveraged ETFs wont track their underlying index with the expected returns.
Many leveraged ETFs can have large opening gaps in either direction. This is
especially true of ETFs for overseas markets, currencies, and commodities that can see
substantial price movement while US equity indexes are closed. Many overseas markets
are actively trading while the US indexes are closed, and the amount of their session
change will be priced into the ETF at the open of trading in the US.
Currency, commodity, and bond ETFs can also make substantial overnight moves
based on foreign trading. Commodity futures open for trading several hours before the
US equity indexes and often see large moves before US equity indexes open. Because of
leverage, the size of the gaps in these ETFs can be greatly magnified. This presents
substantial overnight risk in many leveraged ETFs that investors should always be aware
of.
Seasonality can be an issue with certain ETFs. Agriculture ETFs are prone to
seasonal volume, as are many other commodity or sector ETFs. Before actively trading
an ETF, its a good idea to research the underlying market and potential seasonal
trading patterns. Lower liquidity due to seasonality can result in slippage that can have a
negative impact on gains and magnify losses.
In addition to seasonality, certain sectors may come in and out of play due to
specific news or geopolitical events. Many currency ETFs have been prone to large
moves due to financial events in Europe in recent years, but then declined in volume
and price movement as those issues become resolved.
Investors should also be aware that there is no bottom in ETFs. For example,
during a strong bull market, an inverse ETF for an index may decline until its only a few
dollars in price. When this occurs, ETF issuers often conduct reverse stock splits on
the ETFs to create a higher price. If an investor purchases 100 shares of an ETF at 5.00
per share and a one for ten reverse split is enacted, after the split, the investor will
have only 10 shares at a price of 50.00 per share. While the number of shares owned is
lower, the value of the investment remains the same on the day of the reverse split.
These reverse splits are done to keep the price of ETFs in a price range attractive to
institutions and most investors. However, if the price substantially declines again after a
reverse split, the entire position can essentially be wiped out.
It should be noted that some ETFs pay monthly or quarterly dividends. Always
check to see if an ETF you purchase pays a dividend and the date of the dividend
payment. Since the price of the ETF will be lowered the amount of the dividend payment
after the x-date of the dividend, a stop loss order may need to be adjusted to
accommodate for the adjustment in the ETFs price post dividend.

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 Our Criteria for Selecting ETFs

The criteria we use for selecting ETFs to trade will vary depending on whether were
looking for a long term investment or short term trading opportunities. Regardless of
which, the first thing to examine is how well an ETF tracks its underlying index.
Major index tracking stocks like the SPY, DIA, QQQ, and IWM will track their
underlying indexes almost perfectly. This is also true of major unleveraged commodity
ETFs such as the USO for oil, GLD for gold, and SLV for silver. But in the world of
leveraged ETFs, and even some unleveraged, this isnt always the case. Before actively
trading an ETF, we suggest making a quick comparison of short term returns compared
to the underlying index.
We prefer ETFs that have proven market longevity. ETFs that have been trading for
several years with consistent volume generally do a very good job of tracking their
underlying index in the short term. Several new ETFs are introduced to the markets
virtually every month, while others are cancelled. Generally speaking, the longer an ETF
has been trading, the more consistent its volume and price movement are.
Liquidity is a major point to consider, especially in leveraged ETFs. Large spreads in
a low volume leveraged ETF can create slippage that either cuts into gains or magnifies
losses. We look for highly liquid ETFs that have displayed consistent volume over a long
period of time.
If youre planning on actively trading ETFs on a short term basis as opposed to
longer term investments, we recommend looking for consistent intraday price
movement with the majority of the daily move not all in gaps. Many overseas ETFs will
have the majority of their daily price movement in the morning gap since the actual
underlying market has its trading hours when US equity indexes are closed. While this
may not matter to a long term investor, it means a short term trader can be left with
very little intraday price movement.
We prefer the MSCI Emerging Markets index ETFs for trading in overseas markets.
Because its a basket of stocks from multiple countries, some of the components trade in
countries whose market hours are similar to US indexes. Some of the larger components
of the Emerging Markets index are also actively traded on US exchanges. Although the
Emerging Markets ETFs can still have large gaps due to overseas trading when US
equity markets are closed, they also have consistent intraday price movement during US
trading hours.
We prefer trading ETFs that arent heavily impacted by seasonality. We want to see
consistent volume throughout the trading year. We also believe that the more familiar
we become with a specific trading instrument, the more we understand the trading
patterns of those instruments. For those reasons, we try focus on a handful of ETFs that
meet our primary criteria as opposed to constantly looking for new markets to trade.

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 Our Favorite ETFs

Weve been trading leveraged ETFs since early after their inception. Over the years,
weve carefully studied a wide range of ETFs that trade with consistent volume, price
movement, and generally track their underlying index very well in the short term. The
following list represents our favorite ETFs for trading. If youre new to the ETF market,
these represent a good starting point based on the criteria we look for. Please note that
in each case were providing an ETF Pair, meaning a bull and bear ETF for that
market with equal leverage. In some cases, weve listed the 2x and 3x leveraged ETFs for
a market.

S&P 500 UPRO (3x bull ETF) SPXU (3x inverse or bear ETF)
SSO (2x bull ETF) SDS (2x inverse or bear ETF)

DJIA UDOW (3x bull ETF) SDOW (3x inverse or bear ETF)
DDM (2x bull ETF) DXD (2x inverse or bear ETF)

Nasdaq 100 TQQQ (3x bull ETF) SQQQ (3x inverse or bear ETF)
QLD (2x bull ETF) QID (2x inverse or bear ETF)

Russell 2000 TNA (3x bull ETF) TZA (3x inverse or bear ETF)
UWM (2x bull ETF) TWM (2x inverse or bear ETF)

Emerging Markets EDC (3x bull ETF) EDZ (3x inverse or bear ETF)

Financial Sector FAS (3x bull ETF) FAZ (3x inverse or bear ETF)

Energy Sector ERX (3x bull ETF) ERY (3x inverse or bear ETF)

Silver AGQ (2x bull ETF) ZSL (2x inverse or bear ETF)

Crude Oil UCO (2x bull ETF) SCO (2x inverse or bear ETF)

Gold DGP (2x bull ETN) DZZ (2x inverse or bear ETN)

Note: Although ETNs, the DGP and DZZ typically have higher average volume than the
double leveraged gold ETFs, so we prefer them for short term trading.

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Real Estate Sector DRN (3x bull ETF) DRV (3x inverse or bear ETF)

Semi-conductors SOXL (3x bull ETF) SOXS (3x inverse or bear ETF)

Nasdaq Biotech Index BIB (2x bull ETF) BIS (2x inverse or bear ETF)

Volatility Index VXX (unleveraged ETN) XIV (inverse unleveraged ETN)

Important Note regarding the Volatility Index: The Volatility Index is inherently an
inverse index. The vast majority of the time, the Volatility Index will decline when the
S&P 500 rises, and rise when the S&P 500 declines. The VXX tracks the Volatility Index
and typically rises when the S&P 500 falls. The inverse XIV will typically rise when the
S&P 500 rises. Think of the VXX as inherently a bear ETF, while the XIV is inherently
a bull ETF even though it is an inverse ETF. The Volatility Index is prone to extremely
large intraday price moves. Its daily percentage move can be much greater than even the
3x ETFs for the S&P 500. For that reason, we prefer the unleveraged tracking ETFs,
although there are leveraged ETFs for the Volatility Index as well.

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 A Divergence Strategy for ETFs

At ETF Dynamics, we develop and trade divergence strategies. Divergence is a

popular form of technical analysis based on the principle of divergences forming
between price and technical indicators. We trade several types of divergence, including
basic, hidden, and compound. For the purpose of this strategy, we will focus on basic
divergence, also called regular divergence.
Basic divergence is a method of identifying short term trend reversals as well as
trend continuation moves following a consolidation. A basic divergence occurs when a
technical indicator does the opposite of what price does, creating a divergence between
price and the indicator.
If price makes a low followed by a lower low, but technical indicators make a higher
low at the second price low, then a bullish divergence has developed between price and
the indicator. This divergence would signal a possible reversal from a short term down
trend and an opportunity to go long the market. The following picture illustrates this
principal:

Please note that for a bullish divergence to develop, price could also make a double
bottom instead of a lower low. In that case, the two price lows would be essentially the
same, but the indicator would still make a higher low.

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 For a potential short signal to develop, price would make a high followed by a higher
high (or double top). At the second price high, technical indicators would make a lower
high, signaling a possible decline in price. The picture below shows a bearish divergence
with price making a higher high while a technical indicator makes a lower high.

When looking for price highs and lows, we always want to see a minimum of four
candles between the two price points. If there are fewer than four candles between the
price points, we may simply be looking at noise in a choppy market. The price points
should be well defined with enough space between them that they signify important
price pivots. Its also important to note that indicator highs and lows may lag or lead the
actual price highs and lows by one candle, which is perfectly acceptable. Price highs and
lows are sometimes rounded, occurring over several candles, so indicator high and low
points wont always match price highs and lows to the exact candle.

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Chart Set-up

To outline this divergence strategy, well use the UPRO, the triple leveraged bull
ETF for the S&P 500. Well use a candlestick chart set in a 4 hour (240 minute) time
frame. This is an excellent time frame to capture significant market moves for two day to
two week holds in leveraged ETFs. The strategy works equally as well on daily charts,
although there will be fewer trades set-ups.
The first candle of the day will be the shorter of the two candles since there are only
six and a half hours in a regular trading session. The first candle of the day will end at
noon Eastern time, while the second candle will close at 4:00 pm Eastern time, the
regular session close. Most charting platforms default to this setting when selecting 240
minute candles.
Well use two technical indicators to recognize divergence, one for momentum and
the other for trend. Well also employ price overlay indicators to show an implied
trading range as well as where key price pivots are likely to occur. These same overlay
indicators are useful in placing initial stop loss orders as well as maintaining a trailing
stop if the trade moves in the direction of the signal. The next section will outline how to
use these indicators for the stop strategy.
The first three indicators we add to our chart are the price overlay indicators. This
means they will be on top of the price candlestick section of the chart. Two indicators
are Exponential Moving Averages (EMAs) set at 20 and 50. In the chart picture below,
the 20 EMA is yellow, while the 50 EMA is light blue.
Well also add a Keltner Channel, shown in magenta below. However, WE ALTER
one input to the Keltner Channel to better identify trading ranges for leveraged ETFs.
The input called number of ATRs that is usually a default setting of 1.5 will be changed
to 2.5. Some charting platforms may call this input something different, but it will
usually default to a setting of 1.5. Thats the number that should be changed to 2.5. The
second input for the Keltner Channel, usually called periods or length, should be set
at 20. This is probably the default setting in most charting platforms. If your charting
platform has an average type input for the Keltner Channel, it should be set to
simple.
We are ONLY interested in the outer bands of the Keltner Channel, not the mid-line.
The mid-line is a 20 period simple moving average, but well use our 20 EMA in its
place. We set our Keltner Channel mid-line to transparent to avoid screen clutter. If
your charting platform doesnt include a transparent setting, you can change the color of
the mid-line to match the background color which will essentially make it disappear.

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 The next indicator we add will be a Stochastic. Well place this in the first panel
below price. Unfortunately, Stochastic types and inputs vary across different charting
platforms. In most cases, we will use a slow Stochastic. In Think or Swim, we use the
Stochastic Fast. If your charting platform only offers a single Stochastic indicator, its
most likely a slow Stochastic.
We are ONLY interested in one of the two indicator lines from the Stochastic. In the
slow Stochastic, we will focus on the Slow K (also called %K) line. The other line (Slow D
or %D) can be set to invisible or made the same color as the background of your chart so
that it disappears. We also dont use the overbought/oversold lines so those can be
removed as well. In Think or Swim or any platform that only has a fast Stochastic, we
only use the Fast D. We will turn off the Fast K as well as the Overbought/Oversold
lines.
The names of inputs to the Stochastic vary depending upon which charting platform
you use. In essence, we use a Stochastic setting of 5, 3. This is a much more active
setting for the Stochastic than its default setting.
The following are examples of different charting platforms and how to properly set
the Stochastic inputs for those platforms:

Think or Swim
Use the Study Stochastic Fast

Use Fast D

K Period 5
D Period 3
Price h = high

Turn off show plot for Fast K, Overbought, and Oversold.

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 Tradestation
Use the Slow Stochastic

Use Slow K

Stochastic Length: 5
Smoothing Length 1: 3
Smoothing Length 2: 3
Smoothing Type: 1

Change Slow D to the same color as the background to make it invisible, and do
the same with the overbought and oversold lines.

FreeStockCharts.com
Use Stochastics

Period = 5
%K = 3
Average Type = Simple

Remove the %D, Oversold, and Overbought from the chart.

Metastock
Use Stochastic Oscillator

%K
Time periods: 5
Slowing: 3

%D
Time Periods: 3
Method: Simple
Style: Invisible

The final indicator well add to our chart is a MACD Histogram. If your charting
platform doesnt specifically offer the MACD Histogram as a stand alone indicator, you
can use the histogram from the standard MACD. In all charting platforms, the default
settings for the MACD are the same: 12, 26, 9. We will change those inputs to 9, 20, 9
which are slightly more active settings. When properly configured, your chart should
look like the following picture. Make sure your indicators match ours by selecting the
same date range (May, 2015 to August, 2015) on your chart:

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 When we look at the chart picture above, we want to point out a few important
points. The first is how well the Keltner Channel identifies the trading range over several
months. It is very rare to see price move outside the Keltner Channel for more than a
few candles at these settings.
The second item to take note of is how the 20 EMA and 50 EMA often show areas of
consolidation and support. The picture above shows a relatively range bound market. In
a trending market, the 20 EMA and 50 EMA show areas of expected price pivots during
the trend in virtually any time-frame.
To illustrate this principle, well look at a UPRO daily chart during a strong uptrend
that lasted several months. Notice that on three occasions early in the trend, the 50
EMA provided a support area during retracements. As the trend gained momentum, the
20 EMA provided an area of support for price pivots. As youll see in the next section on
stop management, these two moving averages give us a method of trailing our stop as
well as an anticipated area to look for trade signals to occur during a strong trend.

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If you have any questions regarding your chart set up, please feel free to email us at:

mailto:[email protected]

Copyright 2015 ETF Dynamics, LLC Page 18

Basic Divergence Trade Set-Ups

The first trade set-up well look at is a basic divergence for a long trade, called a
bullish divergence. When price makes a lower low, we want to see BOTH the Stochastic
and MACD Histogram make a higher low. In the example below, when price makes its
lower low, you can clearly see the bullish divergence in the Stochastic and the MACD
Histogram as they both make higher lows. We also want to point out the position of
price relative to the Keltner Channel. On both price lows, price moves outside the lower
band of the Keltner Channel. As we pointed out earlier, its rare at these settings to see
price stay outside the Keltner Channel for more than a few candles. A bullish divergence
forming in the lower end of the implied trading range, meaning the lower band of the
Keltner Channel, creates a high probability trade set-up. At the very least, we expect to
see a bounce into the area between the 20 EMA and 50 EMA.

Lets take a closer look at this same trade set-up so we can discuss trade entry. We
want to see the Stochastic hook up in the direction of our trade, thus completing the
bullish divergence. At the same time, we want to see a green candle to indicate that
momentum is with the direction of our trade. In the picture below, weve circled the
green candle and placed a green arrow above the Stochastic to show the sharp angle up
in the indicator.

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 We enter the trade at the conclusion of the green candle thats circled. In the case of
this trade, it occurred at noon Eastern time. Its important to note that the Stochastic
began angling up on the prior candle, but that candle was red, so for a long signal, we do
not take entry until we see a green candle. Its not uncommon for the Stochastic at this
setting to begin angling up on a red candle, then turn up even more sharply on the green
candle. If the Stochastic had turned back down on the green candle, we would NOT take
entry into the trade. We want to see the Stochastic hooking up with a green candle to
complete the bullish divergence and signal entry into the trade.
To recap our rule set for a basic divergence entry into a long trade:
Price makes a lower low (or double bottom) with at least 4 candles separating
the two price lows.
A bullish divergence, meaning a higher low in both the Stochastic and the
MACD Histogram develops.
We enter the trade at the conclusion of a green candle with the Stochastic
hooking up.
Although its not required for the trade set up, the highest probability basic
divergence trades will either be at the outer band of the Keltner Channel, or
around the area between the 20 EMA and 50 EMA. Basic divergences
around the EMAs often develop after a consolidation during a strong trend.

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 The trade set-up for a basic divergence short signal, or bearish divergence, is
essentially the opposite of a long. Price makes a higher high (or double top) as both the
Stochastic and MACD Histogram make a lower high. In the trade example below, the
two price highs occur on moves through the upper band of the Keltner Channel. As was
the case with the long set-up we looked at, this indicates a high probability area for a
valid bearish divergence.

At the second price high, we see the Stochastic hook down sharply with a red candle.
This is our signal for entry into the trade, and we enter at the close of the circled red
candle with the down arrow above it. Note that this price top is slightly rounded. The
Stochastic was flat for several green candles until it finally turned down with a red
candle. Also, please note that we do not enter trades on dojis. If the Stochastic hooks
on a doji, we wait to see what the next candle is and make sure the Stochastic continues
to hook in the direction of our trade.
Our rule set for basic divergence entry into a short trade:
Price makes a higher high (or double top) with at least 4 candles separating
the two price highs.
A bearish divergence, meaning a lower high in both the Stochastic and the
MACD Histogram develops.
We enter the trade at the conclusion of a red candle with the Stochastic
hooking down.

Copyright 2015 ETF Dynamics, LLC Page 21

Triple Divergence

In addition to basic divergence trades, we look for what is known as triple

divergence. This occurs after a basic divergence trade when a third price point is made
at the same time a second divergence forms in technical indicators. The chart picture
below shows a triple divergence trade set-up for a long.

In the picture above, we see that price essentially makes a triple bottom, although
the second and third price lows are slightly lower than the first. Whats important to
understand in this trade set-up is the divergences in the indicators. The second indicator
points in the Stochastic and MACD Histogram are clearly higher than the first. Note that
the third indicator point in the Stochastic and MACD Histogram is HIGHER than the
first point, but slightly lower than the second point. That is perfectly acceptable. In triple
divergence, we dont care about the relationship between the second and third indicator
points. We only care that BOTH the second point and third point are higher than the
first point. The third point can be higher or lower than the second point but it MUST be
higher than the first point for a valid triple divergence.
Although this triple divergence continued to consolidate for a few days after entry,
the trade soon moved up strongly. In the next section, well examine how we place our
initial stop.
When looking for triple divergence for a short trade, its basically the opposite of the

Copyright 2015 ETF Dynamics, LLC Page 22

criteria for a long. We want to see a price high followed by two additional price highs (or
a triple top). At the second and third price highs, we want both technical indicators to
form points that are lower than the indicator point at the first price high. As is the case
with triple divergence long trades, the relationship between the second and third
indicator points is irrelevant. All that matters is that both the second and third indicator
points are both lower than the first.

IMPORTANT NOTE: Since ETFs trade in pairs, meaning there is a bull and bear
ETF, we could ignore short signals on the bull ETF and simply look for long signals on
the bear ETF. For example, the SPXU is the triple leveraged inverse bear ETF for the
S&P 500. Instead of looking at short signals on the UPRO and then entering the SPXU,
we could just look for long signals on the SPXU. However, we prefer to see a short signal
form on the bull ETF and then simply take a long entry into the bear ETF for several
reasons.
In general, volume is higher and more consistent in bull ETFs than it is in bear
ETFs. Consistent volume produces more accurate signals in technical indicators. There
are times when the bear ETF may set up a long signal, but a short signal does not form
in the bull ETF. We will not take that trade. To avoid uncertainty in situations like this,
and to ensure were getting the most accurate divergence signals possible, we prefer to
always take our trade signals from the bull ETF.
We like to use a long in the bear ETF as opposed to taking a short in the bull
ETF for several reasons. First, by going long a bear ETF, we never have to worry about
shares not being available for a short borrow on the bull ETF. The bear ETF will
also often rise slightly more than the bull ETF declines, so we get a little more out of
the trade by being in the bear ETF. In retirement accounts, short sales are typically not
allowed, so the only option for a short signal is to go long the bear ETF.
Once were long the bear ETF, initial stops and stop management are all done
from the chart for the bear ETF using the same principles well outline in the next
section.

Copyright 2015 ETF Dynamics, LLC Page 23

 Stop Loss and Exit Strategy

Our goal with every trade is to maximize profit by staying with the trade as long as
momentum remains in our direction, while also minimizing risk as quickly as we can.
This is especially important with leveraged ETFs that could fail to track the movement
of the index over a long period of time, or could gap against us due to leverage.

TRADE MANAGEMENT IS CRITICAL FOR SUCCESS WITH LEVERAGED ETFs!

Never enter a trade without a stop strategy in place.

The first element to keeping risk at a minimum is an initial stop loss setting. We
prefer to use dynamic indicators for stop settings as opposed to a simple percentage
basis. The fact is, markets change. We want to have the flexibility to change with them
during periods of increased or decreased volatility. We use a combination of the most
recent price high or low, and either the outer bands of the Keltner Channel, or the 20
and 50 period EMAs to determine where to place our initial stop loss. The position of
price in relationship to these indicators when a trade signal occurs determines which
indicator we use.
We always use a stop loss when we enter a position, and a stop order will be in place
as long as were in a trade. The typical initial stop loss setting is between 4% and 7% of
entry price for triple leveraged ETFs. This is a very reasonable initial setting considering
the 3x leverage.
Well look again at the first divergence trade from the previous section. The entry
price at the close of the green candle was 53.93. For our initial stop loss, we first look at
most recent price low. In addition, we look at the position of the outer band of the
Keltner Channel since price was in that area when the trade signal occurred. Our initial
stop loss setting is below the most recent price low and far enough below the outer band
of the Keltner Channel to allow room for a brief intraday move outside the band. The
short, horizontal line shows where we place the stop after entry, in this case at 51.90,
representing an initial stop loss of less than 4% for a triple leveraged ETF.

Copyright 2015 ETF Dynamics, LLC Page 24

 Once the trade is moving our direction, we make a series of stop adjustments based
on the relationship of price to the two moving averages. Once price moves strongly over
the 20 EMA, well adjust our stop to roughly halfway between the lower band of the
Keltner Channel and the 20 EMA. In this case, the first stop adjustment takes us to the
break even level. Unless theres a large gap against us, weve essentially removed risk
from the trade.

Copyright 2015 ETF Dynamics, LLC Page 25

 In the next chart picture, we see that after a brief consolidation, price continues to
move higher until it touches the upper band of the Keltner Channel. At this point, well
adjust the stop into profit by placing it slightly under where the 20 EMA is. We make
this adjustment as soon as price moves into the upper quarter of the Keltner Channel.
Any time price moves past the halfway point between the 20 EMA and the upper band of
the Keltner Channel (the upper quarter), we will use slightly below the 20 EMA as our
stop setting.
The reason we use slightly under the 20 EMA (usually about 1% of price, meaning
on a 50.00 ETF wed place the stop about .50 cents below the 20 EMA) is to protect
against brief pokes below the 20 EMA. During a consolidation, its not uncommon to
see an intraday test of the 20 EMA as support. We often see a tail on a candle that
briefly trades below the 20 EMA on an intraday basis but recaptures the EMA prior to
the close. We never want to be so tight with our stop that we get taken out of a trade
prior to a big move in our direction.

Copyright 2015 ETF Dynamics, LLC Page 26

 After a retracement to the 20 EMA, price makes a strong move up. The strength of
this move is evident in how long price stays outside the upper band of the Keltner
Channel. Each day that price continues to rise, we slide our stop farther into profit by
trailing it just under the 20 EMA. During a strong move up like this, its not
uncommon to see a mild retracement to the 20 EMA prior to another move up. Our goal
is to stay in the trade if this occurs while also protecting as much profit as possible via
our trailing stop.

Copyright 2015 ETF Dynamics, LLC Page 27

 As price begins to fall back inside the Keltner Channel, a bearish divergence forms
between price and the indicators. We consider this an exit signal but will not take a
short signal yet for two reasons. First, when we see a very strong move of this nature,
highlighted by a long period of time outside the Keltner Channel, we do not take the first
divergence against the trend. The first divergence against a trend of this strength has a
very low probability of winning.
The second reason is when the divergence forms, as shown in the picture below,
there is very little definition in the two price highs. Price has essentially made one steady
rise without a valid first price high, retracement, and move back up into a second price
high. We consider this a messy divergence set up and prefer to avoid signals of this
nature. However, although we will not take a short signal here, we do consider this a
valid exit signal from our long position when price falls back inside the upper band of
the Keltner Channel at the same time we see a bearish divergence in the indicators.

Copyright 2015 ETF Dynamics, LLC Page 28

 We exit the trade at 61.08 from our original entry at 53.93 for a short term gain of
13.25%. With an initial stop of less than 4%, this trade resulted in a over a 3 to 1 reward
to risk ratio. In general, we always try to achieve at least a 2.5 to 1 reward to risk ratio,
meaning the average of our wining trades will be 2.5 times greater than the average of
our losing trades.
For another example of how we place our initial stop, well look again at the triple
divergence long trade from the previous section. For our original stop loss setting, we
look at the most recent price low and the position of the lower band of the Keltner
Channel since price was close to that band when the trade signal occurred. We place our
stop below the most recent price low and slightly below the lower band of the Keltner
Channel. In this case, our stop is at 57.90 from an entry of 62.33. This represents
slightly over a 7% stop loss which is the maximum amount we will ever use for a stop
loss. If either or both of the most recent price low and lower band of the Keltner Channel
required a stop loss of greater than 7%, we would simply use a 7% setting.

Copyright 2015 ETF Dynamics, LLC Page 29

 Once in the trade, price retraces again but stays above the lower band of the Keltner
Channel and well above our initial stop. As soon as price moves up strongly over both
EMAs, we adjust our stop position to slightly under the 20 EMA. In this case, our first
adjustment takes us to the break even level. When price continues to move higher, we
gradually move our stop up into profit using slightly below the 20 EMA as we did in the
first trade example.
Here are a few general rules we use for initial stop placement. As we saw in the two
examples above, if the trade signal occurs with the two price lows at, near, or below the
lower band of the Keltner Channel, our stop will be slightly below the outer band of the
Keltner as well as the most recent price low.
If the trade signal occurs with the two price lows higher than the half-way point
between the lower band of the Keltner Channel and the 20 EMA but below the two
EMAs, we will set the initial stop about 1% below the most recent price low, but not
below the lower band of the Keltner Channel if that would result in a stop loss of more
than 7%. To demonstrate this, well look at a triple divergence from a TNA daily chart
below. We also want to point out in this trade set up how a basic divergence formed
between price and the Stochastic at the second indicator point, but the MACD
Histogram did not confirm that divergence. For that reason, we do not consider the first
basic divergence trade valid and we do not enter the trade. When the triple divergence
forms in the Stochastic, the MACD Histogram DID confirm the divergence. That
validates the triple divergence trade.

Copyright 2015 ETF Dynamics, LLC Page 30

 If the trade signal occurs with the two price lows at or above the 20 and 50 EMAs,
we will us slightly below the most recent price low and slightly below the lower of the
two EMAs. To demonstrate this stop placement, well look at an EDC daily chart. This
type of set-up is most likely to occur on daily charts, and not in the 240 minute time
frame.

Copyright 2015 ETF Dynamics, LLC Page 31

 Regardless of where our original stop is placed, once price moves strongly over the
two EMAs, we use slightly below the 20 EMA as our trailing stop position.
One last note regarding exits. A bearish divergence will not always develop to signal
an exit from a trade. If price moves above the upper band of the Keltner Channel and
falls back inside on three separate occasions, we will always exit the trade on the third
return inside the Keltner Channel. At that point, the trend has become overextended
and will more than likely return to the 20 EMA for a consolidation.
In the case of a short signal, a reminder that we would take the trade by going long
the inverse bear ETF. That means our stop strategy would work exactly the same for
the bear ETF as it does for the bull ETF.

Copyright 2015 ETF Dynamics, LLC Page 32

 ETF Resources

If youre interested in more information about ETFs as well as resources for

researching the broad range of ETF products available, we recommend the following
websites. Please note that we are in no way affiliated with any of these companies and
provide these links as a courtesy to our clients.

General ETF Information:

ETF Database http://etfdb.com/

Investopedia http://www.investopedia.com/terms/e/etf.asp

Stock Encyclopedia http://etf.stock-encyclopedia.com/

Morningstar http://www.morningstar.com/etfs.html

Major ETF and ETN Issuers:

Direxion http://www.direxioninvestments.com/

Proshares http://www.proshares.com/

Velocity Shares http://www.velocityshares.com/

Barclays Ipath http://www.ipathetn.com/US/16/en/home.app

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