Before we continue, there is something really, really important that I need to tell you about ratios. That is, if you’re using two different types of financial instruments, like the SPY or the TLT, or if you’re using two similar instruments, indexes like the S&P 500 and the Emerging Market ETF, EEM – just because this trend is down doesn’t mean that the EEM is necessarily going down as well, or the SPX is actually going higher, and it’s outperforming the EEM. The actuality is that this is a ratio. Remember, they’re called ratio spreads. They are ratio charts.
In this case, the S&P 500 actually did outperform the EEM, but it may mean that they’re both going down at the same time, and SPX, the S&P 500 index, is going down slower than the EEM. It doesn’t necessarily mean that it’s going up. It is outperforming, because it’s going down slower. When I say go long or go short these issues, it just means that you want to look to see which one is outperforming the other one in an uptrending market.
The first thing you need to do is identify what the market is. If the market is trending higher, then you want to look and go long those issues that are outperforming. If the market is going down, then you want to go short those issues that are underperforming. It’s a very, very important distinction that you need to make, when using ratio charts.
Now, what I’m going to show you is a way to determine when to go long or short the general market. The reason why this is such a big secret is because these types of ETF, the ones I’m going to introduce to you, have only been out now for a couple of years.
What I’m talking about are short ETFs. Those are ETFs that you short the market with. This is really critical. This is no guarantee that you’re going to actually make money in the market, but I can tell you, the dynamics with the long ETFs and the short ETFs is nothing short of dramatic. This is one secret that the top 1% of traders have been using since 2006, when many of these short ETFs started to make their appearance.
Let me give you an example. Right now, we’re on a 2-year chart. Let me go back 5 years. We’re going to keep the line chart on, only because it’s easier to identify what’s happening to these issues. Let’s go to the SPY. The opposite of the SPY, the short ITF for the S&P 500, is the SDS. Now, there are many short ETFs. There are one-time ETFs, two-time ETFs, and three-time ETFs. What that means is that they are either double the long ETF, or triple the long ETF of the index. They do that by leveraging derivatives and Futures contracts. We’re only interested in the one-time short ETFs. They are the opposite trading vehicle for the long ETFs, for the indexes. In other words, we want to use the SPY, and we want to use the SDS. The SDS is the short version of the UltraShort S&P 500 version of the ETF for the S&P 500. What we want to do is plot the SPY. You can see the SDS in front of you. It has been in a major bear trend since March of 2009, when the market actually hit its bottom, after the financial decline. It’s been in an extreme downtrend, hitting $19.26 today. Let’s go to the SPY. You can see that since March of 2009, it’s been in the opposite trend. But let’s plot the two of them together, and see what we can find. You can look at this, and say, “Well, maybe this is a good time to go long, or maybe it’s not.” It’s very difficult to tell, based on using a single chart. If you plot one against the other, it’s a little bit easier to see where the tops and bottoms are. Let me show you what I mean. What we’re going to do is, we’re going to go over to our Chart Settings. We’re going to go to Left Scale, and add a left price scale chart. What we’re going to add is the SDS, which is the short ETF for the S&P 500. A very interesting phenomenon starts to take place when we do that. We’re on a weekly chart. We’re going back 5 years. You’ll see something extremely interesting, and that is that there are times when they cross each other, almost like an oscillator. You have a bottoming process, a topping process, a cross, and then a cross again. Take this in for a second. The black line here is the SPY. The blue line, on the left scale, is the SDS, which is the short ETF for the S&P 500. You notice something quite interesting. You’ll see this rounding process. When the SPYs were starting this rounding process, the SDS was mimicking the same thing, in a bottoming process. You have a very rounded bottom here, and you have a somewhat jagged top on the SPY. What it did was alert me to the fact that this market was ready to start declining, because of this rounding bottom. We’re getting back into almost the same situation again. We’re starting to see a stabilization in the SDS, at the bottom, while we’re getting a lot of jagged tops on the SPY on the right.