ETF Trading System Designed for Emerging Markets

Trading Emerging Markets can be a tribulation. Each trading analysis system I had tested was a dreadful failure. I could not eke out any gains without experiencing unacceptable draw downs. On account of the volatility of the emerging markets, represented by the ETF named EEM, the draw downs were much too large for any sane human to trade.

In my opinion, Draw down is one of the most critical factors to consider. People come up with amazing trading systems that make a good deal of money, but only a computer can trade them. A human, with his emotions, would never be able to take the next trade after experiencing a huge loss or series of large losses.

Many mutual funds use the S&P 500 as their yardstick. Yet, few of these funds have an historic performance record superior to the S&P 500. This is one indication that the S&P 500 is not easy to trade. Given these facts, successfully trading EEM appears to be an insurmountable challenge.

However, this article presents a proxy strategy for trading EEM using an already successful strategy used to trade the S&P 500. The S&P 500 strategy, trading the ETF, SPX, employs money management and market timing to capture excellent returns. An adaptation of this strategy is employed for trading Emerging Markets to achieve outstanding returns without suffering serious draw down.

5 Year Daily Percent Gain Chart of SPX [black] vs EEM [green]

SPX is a stock symbol for trading the S&P 500; EEM is the stock symbol for Emerging Markets.

If you study the relative movement of these two items in the above chart, you will see that EEM [green], moves in the same direction as the SPX [black], but the movement is exaggerated. However, their peaks and valleys line up relatively well. It is difficult to predict the extent or amplitude of the relative movement, but the prediction of the direction is solid.

In summary, we can say:

EEM is much more volatile tha SPX.

EEM tends to move in the same direction as SPX.

The relative price change of EEM is uncorrelated relative to the corresponding change of SPX.

I use a proprietary market timer based on several factors related to the S&P 500. Other market timers may also work. The key to trading the S&P 500 is the following money management strategy; stop-losses are not employed.

The market timing strategy is straight forward:

When the timer is bullish buy EEM when it starts moving up.

When the timer is bearish, short EEM when it starts moving down.

When the timer is neutral, stay on the sidelines in cash.

In bear markets EEM is shorted. This is not permitted in IRAs. However, EEM has an inverse ETF, EUM. Rather than short EEM, buy EUM. This eliminates the IRA restriction.

Here is a brief description of the adapted money management strategy:

When the SPX has gained 5% from its start at the market timer signal, sell 25% of your EEM shares.?

For each subsequent gain of 5% of the SPX, sell half the remaining EEM shares.

Note: this is the identical money management strategy used to trade leveraged ETFs for the S&P 500. Except in this case, we are substituting EEM for trades of the ETFs.

This strategy was back-tested 11/22/06 to 11/18/10.

$100,000 grew to $356,850

Average Annual Rate of Return = 64.39%

Maximum Draw-Down = -7.15%

Percent winning trades = 84.62%

If you were among the many whose equity suffered in the 2008 market collapse, this strategy should be considered. If you like a more consistent, less exciting, easier to trade strategy, you should probably look at trading SPX using a timer with the proper money management.

In summary: We conquer the violent moves of EEM using SPX as a trading proxy. Using the same market timing and successful money management strategy that we use to trade SPX, we can trade EEM.