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MULTIPLE MOVING AVERAGES In last week's "INSIDE THE BLACK BOX" section we discussed the importance of moving averages. A moving average, it was pointed out, is a curved trendline. Like a diagonal trendline, a moving average allows you to trade in harmony with the trend. The moving average, like the trendline, provides support and resistance. A bullish stock has a chart whose price is above an upward-sloping moving average, while a bearish chart has a stock whose price is below a downward-sloping moving average. All of us have heard the cliché, the "trend is your friend." But the cliché begs the question of which trend is named. At least three trends can be identified on any chart -- the primary (or long-term) trend, the intermediate trend, and the short-term (or minor) trend. The primary trend typically lasts for at least a year. Meanwhile, the intermediate trend is thought of as being at least three weeks to perhaps three months in duration. And finally, the short-term trend may last several days. Sometimes all three trends are in alignment with one another. At other times, however, the trends may contradict one another. The S&P, for example, could be in a primary uptrend, in the middle of an intermediate downtrend, and in short-term uptrend all at the same time. As a swing trader you must be very clear to identify which trend is your friend. Swing traders must be attuned to the minor trend as they look to capitalize on short-term moves that may last from a few days to at most a few weeks. However, if your exclusive focus is just on the near-term picture, then you will often get hit with nasty surprises. Let's say -- as described above -- we are in a long-term uptrend, an intermediate-term downtrend and a short-term uptrend. In this particular scenario, a swing trader who ignores the intermediate-term downtrend could be headed for serious trouble. For example, after analyzing the bullish short-term uptrend, the trader might decide to initiate several aggressive long positions. However, this trader is likely to get slapped with heavy losses when the intermediate-term downtrend reasserts itself. By combining multiple moving averages, you'll be able to come up with a clear answer to what the trend is in different time frames and whether the trends in the different time frames are aligned with one another. The moving averages I describe below are for the following days: 4, 9, 20, 30, 50, 150 and 200. They are simple (not exponential) moving averages. These are my "favorites," and you can view all of them below in the chart of McDATA, which I will analyze shortly. Different technicians will swear by the 40-day moving average or will extol the virtues of combining the eight-day moving average with the 32-day or the power of the 65-day moving average. However, I don't think any single moving average is "the right one." Once you have found a combination that works for you, then stick by it so you get a feel for the signals that those particular averages generate. There is no one moving average or combination with a special power; the key point is to represent the moving averages in various, multiple time frames. Here's why I have decided to focus on each of these particular time periods:
In any good charting package, you should be able to place all of these moving averages on the same chart. While at first this practice may seem like information overload, you will quickly adjust to these types of charts (and your persistence will be rewarded with more accurate trading signals).
There are three distinct periods of the McDATA chart I want to discuss.
Combining moving averages from multiple time frames allows you to determine when the trends from all three periods are in your favor. By synthesizing all of these various moving averages, you will greatly increase your chances of profitable swing trading. Below I will discuss in detail the signals given when the moving averages cross over one another...
Alert swing traders will find moving averages extremely useful because they help to keep you in a trade for the duration of a trend. As long as price remains above the key moving averages and the moving averages are trading above one another in what I've labeled "bullish alignment," traders should hold their long positions. If price is below the key moving average and the averages are in "bearish alignment," then that particular stock should be held short. Moving averages also give trading signals when they move through each other. Technical analysts call these signals "moving average crossovers." When the shorter-term moving average crosses above the longer-term moving average, this creates a buy signal. When the shorter-term moving averages cross below the longer-term, this creates a sell signal. When deciding which moving averages to employ in their trading system, swing traders can use as few as two moving averages or as many as three or more. These moving averages should be combined with other technical analysis tools such as candlesticks and indicators such as MACD to make trading decisions. A moving average crossover system of great importance to swing traders was made popular by R.C. Allen. This system involves the 4, 9, and 18-day moving averages. Allen created his system well before Bollinger bands were created, and I have modified his concept slightly by substituting a 20-day moving average for the 18-day. This change gives me the advantage of adding a Bollinger band to the chart without creating visual clutter. According to Allen's system, a cross of the 4-day above the 18-day is an early signal that the trend has changed to bullish. When the 9-day crosses above the 18-day, this change in trend is confirmed and a buy signal is created. It's worth noting that at that time, of course, all three moving averages will be in "bullish alignment" with each other and all three will also likely be sloping upward. When the uptrend is in the process of reversing, an early indication of trend change will take place when the 4-day moving average crosses down through the 9-day. A swing trader might want to nail down profits at this time even though a confirmed signal has not yet been given. The confirmation does come when both moving averages cross below the 18-day and all three averages are in "bearish alignment." I've illustrated this trading system by examining a historical chart of (McDATA), which we have been using as our example to discuss moving averages. Note that for the entire month of September, MCDTA was mired in a steep downtrend and was "riding" the lower Bollinger band. The 4-day moving average was consistently below the 9-day throughout this period, and both moving averages were sloping downward. The dotted line, which represents the 20-day moving average of the Bollinger band, was above both the 4-day and the 9-day, and was also headed south.
The first moving average warning that the trend was changing occurred at the point marked "1" in the chart above, where the 4-day moving average penetrated upward through the 9-day. If the swing trader had been short McDATA at that time, then a shot across the bow had been fired and short positions should have been covered. Very shortly thereafter (at point #2) the 4-day moving average crossed above the 20-day, providing a preliminary buy signal. This signal was confirmed four trading days later (point #3) when the 9-day crossed through the 20-day moving average. Note that during this period MACD flashed a buy signal and the downtrend line broke, giving several indications that the short-term trend had reversed and there was money to be made by being long. That crossover took place in mid-October at just above the $6 level. The corresponding warning to take profits was not given until the end of November when McDATA was trading near $9. Throughout this intervening period, all three moving averages were in "bullish alignment" -- signaling it was profitable to remain in the trade by being long. On the first day of December, the 4-day moving average crossed below the 9-day, providing the signal to take profits (point #4). Almost simultaneously, MACD gave a sell signal and the uptrend line was violated. A few trading days later (point #5) the 9-day moving average crossed below the 20-day and all three moving averages were now in bearish alignment. A short sale was now safe. Moving average crossovers provide powerful trading signals, particularly when used in conjunction with other technical analysis tools. The 4, 9 and 18-day (or 20-day) moving averages are a very helpful guide to making swing trading decisions. Try applying them to stocks you currently own to see if you are trading in harmony with the short-term, or swing trading, trend. |
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