The last post established the characteristics a successful trader should embody. But just being in control of emotions without any actual technical knowledge will not make you profitable in the markets. So let´s get started with some technical lessons (again, YEAAAAAH). Just as the last time the source of my newly acquired knowledge is a book by Steve and Holy Burns. “Moving Averages: Incredible Signals That Will Make You Money In the Markets” introduces the basics of moving averages and I only can recommend reading it. The knowledge is pure gold (especially given the fact that it does not even cost three bucks).But lets get started.
Many of the most successful technical traders dedicate a lot of their success in trading to moving averages. Why and more importantly what are moving averages? Moving averages are prices averaged over a specific time frame, for example the average of price of the last 10 days. These indicators help to judge where the price of a stock currently is trading compared to the average price. Thus they constitute technical tools for the identification of trends. Moving averages can be calculated for different time spans and the longer the period the calculation is based on the easier it gets to observe trends in the chart since the short term noise is filtered out. However during high volatility moving averages tend to be less useful since emotions take over in these kinds of markets. The undeniable benefit of these technical tools is that moving averages depict quantifiable facts. No guesswork has to be done in order to express the past trend up the the actual moment. The below chart depicts both the German DAX index and two moving averages (50 and 200 days) allowing to judge the momentary price development compared to the historical average.
There are three kinds of moving averages: simple, weighted and exponential moving averages. A simple moving average (SMA) is a normal average calculation of the prices of the asset. A Weighted moving average (WMA) gives more weight to recent than past prices in the calculation of the average. Similarly does an exponential moving average (EMA). However the difference in weights between prices of different time frames in this case is exponential and does not remain the same. Now let´s have a look at a few different moving averages and their possible use.
5 Days Exponential Moving Average
The 5 days EMA captures the momentum of the market. It only should be used in low volatility markets with strong momentum and can indicate possible trends on a daily basis. A breakthrough of this level might be a possible indications of a trend. In conjunction with the RSI (see beneath) this indicator can mark entry and exit points. Additionally it might be of use as a trailing stop after a breakthrough of a longer time frame moving average as well as a end of day trailing stop. The time frame trading this moving average is only up to two weeks and profits should not run too far above this chart because prices usually will return to it.
10 Days Exponential Moving Average
Similar to the 5 day EMA this moving average gives indication about the short term trend and should not be used in volatile markets that daily break through the line. It can be used in daytrading and is supposed to keep you on the right side of the trend. This line usually is the first to be lost before a stock gets into trouble. Additionally it can be used in conjunction with other moving averages such as the 200 days SMA in order to obtain long and short signals.
21 Days Exponential Moving Average
The 21 days EMA usually is the last line of support in volatile uptrend. The time frame is intermediate it can keep you on right side of volatile stocks. It might be used in conjunction with the RSI to cover long and short positions. The Netflix chart below (yeah, I still am very attached to this stock) shows how the 21 days EMA could be applied together with the 50 days SMA. At the same time we see that the indicator alone might be misleading. When the shorter term 21 days EMA crosses over the longer term 50 days SMA this seems to be a long indicator while the opposite seems to hold when the longer term crosses over the shorter term moving average.
50 Days Simple Moving Average
The 50 days SMA might keep you on the winning side of a trade for many months. In uptrends it often functions as support level and as resistance in downtrends. As we just saw in the previous example it can be used profitability together with the 21 days EMA.
100 Days Simple Moving Average
As an intermediate between 50 and 200 days SMA´s if this indicator is not hold often the next stop is the 200 days SMA. In bull markets this line often yields a great risk reward ratio.
200 Days Simple Moving Average
This probably is the strongest signal telling you which side to be on. If prices trend above this line a bull is likely whereas prices below indicate a bearish development. First of all this makes you strengthen defense by being on the right side of a market. After a bear market a break through the 200 days SMA gives you a good risk reward ratio. Additionally, this moving average can provide a strong support level for growth stocks.
Moving averages may be very useful but often alone trigger false signals. Crossover systems use two moving averages that give signals when the shorter term moving average crosses over longer term moving average. This enhances the quality of signals compared to a simple moving average. Above we already saw the possible combination of the 21 days EMA and the 50 days SMA. In order to catch large price swings a use of the 10 and 30 days EMA might be applicable. Long term trend followers look for a signal called the “golden cross” which is triggered by a crossing of the 50 over 200 days SMA.
Besides crossovers of two moving averages some other indicators can aid the trader in making entry and exit decisions. One of them is the Relative Strength Indicator (RSI). The RSI is an index measuring relative strength in the market. It compares the magnitude of recent gains to recent losses and thus is supposed to indicate whether the market is oversold or overbought. The index yields a value between 0 and 100 where a values of 70 and 30 indicate overbought and oversold markets respectively. The next chart shows how the RSI (on the top of the chart) may be useful in deciding whether to exit or enter. At the very bottom of the market the RSI indicates that the stock is severely overbold and thus might give an entry signal even prior to the crossover of the moving averages.
Wow, there are many different moving averages and it is not that easy to interpret them.But who expected trading to be an easy thing. Personally, I took a lot of useful knowledge out of this book. When reading it and detecting patterns in the charts my interest for investing was further strengthened and I look forward to test the systems and then finally apply them (hopefully successful).